The UK equity market fell during July, as broadly weak second quarter earnings from companies illustrated the difficult trading backdrop and some elements of ‘lockdown’ easing were pushed back (for example the portfolio holds a position in bowling operator Ten Entertainment, which had been due to open its sites in England on 1^st August, and this has since been pushed back to the 15^th August at the earliest). At the sector level, this difficult trading backdrop was illustrated in cyclical sectors (such as financials, industrials and energy) underperforming, while information technology was the best performing sector as it continues to benefit from being one of the only structurally growing areas.

The largest detractor from performance during the month was aerospace components supplier Senior. Production rates of aeroplanes continue to be scaled back by the two largest manufacturers (Airbus and Boeing) due to the very difficult outlook within civil aerospace. This is having a knock-on impact throughout the supply chain, including Senior. The largest contributor to performance was Direct Line, where its motor insurance business is proving defensive in the current downturn and it was expected they would announce a return to paying dividends (following the month end they announced they were paying an interim dividend and a catch up of the previously suspended final dividend).

During the month the positions in Rolls-Royce, Croda and Avon Rubber were reduced. In the case of Croda (speciality chemicals) and Avon Rubber (defence equipment), both had performed well on an absolute and relative basis and in our view there were better opportunities for total return elsewhere. Engine maker Rolls-Royce had been a very disappointing performer year to date as approximately half group sales come from civil aerospace, where both aftermarket sales and new engine deliveries will be down markedly this year. In managing the portfolio we are assessing the ability of companies to pay dividends on a two to three year time horizon.  Given the scale of cash outflow that Rolls-Royce are guiding to this year, in our view their ability to pay dividends will be limited for the foreseeable future, therefore we significantly reduced the holding.  We added to existing positions in Hipgnosis Songs Fund (which raised money via a C-share issue to fund acquisitions of additional back catalogues of songs) and K3 Capital (which raised money to fund two acquisitions in adjacent areas).

The UK economic backdrop remains highly uncertain with a very broad range of analyst forecasts. There are additional complicating factors, for example the true unemployment rate is currently being masked by government support schemes and will only become evident once these are wound down in the autumn. There are some positives; we continue to be impressed by the operational flexibility and management strength of many of the companies in the portfolio. We are also pleased to see (tentative) signs of dividends resuming following severe dividend cuts earlier this year. Examples so far include BAE Systems and IMI, both of which are paying final dividends that were previously suspended along with interim dividends. We expect there to be further announcements of this nature in the upcoming weeks.

Glossary

Cyclical sector: a type of sector that is sensitive to the business cycle, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction

Dividend: A payment made by a company to its shareholders. The amount is variable, and is paid as a portion of the company’s profits.