UK equity markets continued to recover during May from their lows in mid March, with the FTSE All-share rising 3.4% on a total return basis. Within this market rise there was an interesting change in leadership of the market, with cyclical sectors such as Materials outperforming, while some defensive sectors such as Utilities underperformed. This represented a shift from April where the market rise was driven predominantly by defensive sectors. In our view this leadership change reflected some encouraging initial (albeit fairly anecdotal) data as some economies partially eased their lockdown restrictions.

Within the Lowland portfolio the largest contributor to performance during May was Avon Rubber, a supplier of predominantly defence equipment such as protective masks and body armour. This had encouraging results in which the business grew well organically and operations were relatively insulated from any disruptive effects of Covid-19. Another strong performer was retailer Halfords, which reported an encouraging recent trading update. The majority of stores have remained open during the UK ‘lockdown’ and its cycling range in particular has benefitted from being an alternative to public transport.

Among the largest detractors from performance at the stock level was engine designer and manufacturer Rolls-Royce. Civil aerospace more broadly has been detractor from performance in the portfolio, with two industrial holdings that are materially exposed to the area – Senior and Rolls-Royce. Civil aerospace had been a structurally growing area in recent years with passenger miles flown growing at more than 2x global GDP growth. However, the current downturn will be worse for the aviation industry than the financial crisis or 9/11; the majority of the global plane fleet is currently grounded. For Rolls-Royce this means less need for their aftermarket services for engines, where the majority of profits are made. The management team are making good progress on cost savings and the valuation is low versus history, therefore we have maintained the holding.

During the month the position in Sabre Insurance was reduced and a new holding was established in RSA. Sabre has been a strong performer for the portfolio over time and as a result it is trading at a valuation premium to the UK insurance sector. In contrast RSA is trading at a large valuation discount versus history and has clearly laid out what it estimates its Covid-19 related claims to be. While RSA is not currently paying a dividend following guidance from the insurance regulator, their management have made it clear that they wish to restart their dividend as soon as they are able to do so. A new small position was also added in global cinema operator Cineworld. This had performed very poorly year to date as a result of its cinemas globally being closed. However its recent trading update confirmed cinemas are due to re-open starting in July and they have received a short term covenant waiver from their lenders during this difficult period.

The Trust continues to hold a significant weighting in the Industrials sector. The short-term earnings outlook is undoubtedly difficult, more so in some areas than others – civil aerospace is a particularly difficult area while other end markets such as defence, semiconductors and infrastructure spending are holding up comparatively better. In response to this end market weakness companies are responding fast, pulling cost levers such as reducing capital expenditure, reducing headcount and (where necessary) reducing other cash outflows such as suspending dividend payments. This reduction in the cost base means that when sales recover, in our view the drop through from sales to earnings will be substantial. This could come at a time when valuation levels versus historic sales and earnings are low. Therefore while the Industrials weighting has detracted from returns year to date, the Trust has maintained its current positioning in the area.

Glossary

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.