Banks, utilities and real estate are among the best UK domestic ideas in the HL Select UK Income Shares fund, according to Hargreaves Lansdown manager Charlie Huggins.
However, investors need to understand the difference between investing in UK-listed companies that are domestically focused and those with a more international presence.
Indeed, while the fund invests in UK listed businesses, over half of the sales generated by these businesses are earned overseas.
“Investors are understandably nervous about the UK’s economic prospects at the moment. However, it is important not to confuse the outlook for the UK economy with that of the UK stock market,” Huggins said.
“The majority of UK-listed businesses generate the bulk of their profits overseas and have actually benefitted from sterling weakness following the Brexit vote.”
He noted that from his estimates, the split between domestic earnings and overseas earnings is relatively evenly split, as the below chart shows.
Source: Hargreaves Lansdown
To understand where revenues come from, the firm estimated the proportion of UK sales for each of its holdings and calculated a weighted average for the fund.
“We cannot be exact because companies do not always disclose sales by country, but we the think the chart [above] gives a very good approximation from our analysis,” Huggins noted.
As such, about one-third of the holdings in the fund are internationally focused, generating less than a fifth of their sales in the UK.
Meanwhile, around one-third are largely domestic-facing stocks, generating over four fifths of their sales in the UK. The remaining third of the portfolio sits somewhere between the two themes.
Focusing on the companies that are largely domestic, the manager said there are a number of stocks that should be prove “relatively immune” to the uncertainty surrounding the domestic economy as negotiations to exit the EU continue.
The first is real estate trusts Tritax Big Box and Primary Health Properties (PHP), which Huggins said should be able to withstand a dip in the economy despite generating all of their profits from the UK & Ireland.
“Tritax leases distribution centres to a roster of blue-chip clients, with demand strongly linked to the growth of e-commerce,” he said.
“PHP owns a portfolio of specialist buildings that are leased to healthcare operators, meaning the vast majority of its income is backed by the UK government.
“Both companies have their customers signed up to very long leases, with upward-only rent reviews reinforcing the security of these income streams.”
Performance of stocks vs FTSE All Share over 3yrs
Source: FE Analytics
Over the last three years, both stocks have beaten the wider FTSE All Share’s 27.37 per cent rise, returning 50.80 and 70.64 per cent respectively.
Another area that should be able to weather any potential storm in the UK economy are utilities, which much like the companies above have sources of income backed by strong demand.
“Our need for water, electricity and gas will not go away regardless of what the latest GDP figures say,” the manager said. In this space Huggins uses water company Pennon and electricity provider National Grid.
“Both businesses are heavily regulated and so long as they operate their businesses efficiently, the regulator should allow them to earn an adequate return from their activities,” he said.
There are areas that the manager is happy to invest in despite being closely correlated to the UK economy. One such area is the financials sector, and more specifically banks.
Banks represent an 8.33 per cent weighting in the fund, and includes Close Brothers (4.1 per cent) and Lloyds (4.23 per cent).
The stocks have had contrasting fortunes since the financial crisis of 2008, with Close Brothers up by 191.37 per cent over the last decade while Lloyds has fallen by 31.87 per.
Performance of stocks vs FTSE All Share over 10yrs
Source: FE Analytics
“We believe both are well positioned to weather any storms. Lloyds is a lot less racy these days having simplified the business, cut costs and strengthened its balance sheet,” Huggins said.
“Meanwhile Close Brother’s conservative approach to lending has served it well historically, enabling it to grow or maintain its dividend every year since 1999, despite the extraordinary economic events along the way.”
The final domestic sector the manager is backing are those that are focused on the UK consumer. In this space the fund owns pub operator Greene King, soft-drinks manufacturer Britvic, and Domino’s Pizza.
“These companies clearly aren’t immune from the UK economic backdrop, and in recent months both Greene King and Domino’s have warned of a slowdown in consumer spending,” he noted.
However, they should prove more resilient than large ticket manufacturers, Huggins argued, as in tough economic times people are more likely to cut back large items than on comfort luxuries.
“People are more likely to cut back on clothing, sofas, houses and cars than they are on a pint down the local pub, a takeaway pizza or a can of soda,” the manager said.
In contrast, the fund has zero exposure to housebuilding, construction, home improvement or general retailing, which have traditionally been amongst the most susceptible to the vagaries of the economic trajectory, he noted.