Lowland says UK still cheap as it outperforms

Lowland has published results for the year ended 30 September 2024 and they are good. The NAV return came in at 16.3%, ahead of the 13.4% return posted by the All-Share. The discount narrowed from 14.2% to 13.1% [still too wide but headed in the right direction], which meant that shareholders got a return of 18.3% – by James Carthew

The dividend was hiked from 6.25p to 6.425p. This dividend was not quite fully covered by revenue earnings (which were 6.29p per share), but the board says that it has confidence that earnings will resume their upward trajectory, and is committed to maintaining its quarterly progressive dividend. The chairman says that Lowland has chosen to prioritise longer term gains in growing capital which will facilitate income growth in due course, and steadfastly declined to chase earnings. During this year a number of highly rewarding investments, such as Marks and Spencer and Rolls-Royce, had zero or lower dividend yields but were in this category. Timing was an issue with some major dividends being paid just after the year-end, and foreign exchange, interest rates and a trend to replace special dividends by share buy-backs were also factors.

The chairman also observes that, while there has been some improvement in UK valuations since last year, this has not really affected the smaller sector or, to a major extent, those stocks with a particular UK focus. Lowland’s portfolio is on a Price/Earnings ratio of 10.2 times, or 8.9 on a ‘look-though’ basis, taking its discount into account. The market continues to bear a substantial discount to international peers. The trust’s outperformance during the year is predominantly attributable to stock picking. Take-over activity was helpful, in itself emphasising the humble valuations prevailing in UK markets, and the company also benefitted from gearing, one of the opportunities open to investment trusts.

Extracts from the manager’s report

The company’s return during the financial year was driven predominantly by its FTSE 100 and FTSE 250 holdings, with positive stock selection in both indices (comparing the third and fifth columns in the table below). There was also positive stock selection within AIM portfolio holdings, although the underperformance of AIM more broadly compared to the main market meant that despite positive stock selection, our holdings in this area remained an overall detractor from relative returns. Within the FTSE SmallCap Index (which is now a relatively small index, outside of investment companies) stock selection was negative, driven by the holdings in Vanquis Banking Group and TT Electronics.

When viewed through a different lens, what can be seen is that size allocation of the portfolio (in other words the company holding more than its benchmark in small and medium sized companies) was not a big driver of relative performance this year, and instead it was stock selection and to a lesser extent the use of gearing that drove the relative return.

Within the FTSE 100, the good performance was driven predominantly by the holdings in Rolls-Royce and Marks & Spencer, as well as banks NatWest and Barclays. Rolls-Royce benefitted from a combination of favourable end markets and ongoing ‘self-help’ (such as cost cutting and a more commercial focus on pricing). The position was sold during the financial year as the valuation had recovered a long way at the same time as market expectations had become more realistic. The holding was a good reminder that non-dividend payers can serve a role within an income portfolio, as the capital growth from Rolls-Royce can now be reinvested. M&S continued its recent outperformance as a result of higher than forecast earnings as well as a higher valuation, as both sides of its business (food and clothing) performed well under the new team. We have recently reduced the holding as its turnaround is now better understood and reflected in valuations. The banks performed well in an environment of more ‘normal’ interest rates, where they can earn a healthier margin between what they charge for lending and what they pay out for deposits.

Turning to the FTSE 250, the best performers included pork and poultry processor Cranswick, contractor Balfour Beatty, ship broker Clarkson and building products company Marshalls. While there would be no end market commonality to these businesses, each would be among the market leaders in their area with a path to further earnings growth. For example, in the case of Cranswick, they are already the market leader in pork and are now investing in chicken, while in the case of Marshalls there is a need to build more housing and with this will come greater demand for its products.

Within the FTSE SmallCap index, while there were positions (such as free-to-air broadcaster STV) that performed well, there were two key detractors – Vanquis Banking and TT Electronics. In the case of Vanquis (which is predominantly a provider of credit cards), profitability is currently minimal as the new management team work through a number of issues (such as higher than expected claims costs and the need to move prices up in some areas in order to generate a good return). With respect to the claim costs, higher claims were largely driven by external claims companies, and the uphold rate of the complaints has been low, but nevertheless there is a charge from the financial ombudsman for any complaint (regardless of whether it is upheld). The holding has been poor and the company has gone through several phases of restructuring over a number of years. The valuation is currently very low relative to the potential returns the company would earn if the new team do succeed in turning the business round. In the case of TT Electronics the company substantially lowered earnings guidance as a result of challenging industrial end markets. In the period after Covid, due to supply chain outages there was a period where customers built up stock levels to much higher than normal levels, in order to ensure they wouldn’t be caught out by not having a particular component. What followed were several years of ‘unwinding’, as stock levels were steadily moved back to normal levels. At the same time higher interest rates have been depressing demand. For a company such as TT Electronics, if and when demand recovers, we would expect a substantial earnings recovery.

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