UK Equity Income sector sees three-year performance bolstered by small-cap exposure and diversification of dividends
Playing the UK stock market over the past three years has been a game of two halves. Managers faced a battle to beat their peers as markets soared in early 2007, and then plummeted when the credit crisis took hold.
Income seekers in the UK have faced the dual challenge of preserving both capital and income during a turbulent period for dividends, as banks and oil major BP were forced to cut their payouts.
Within the IMA’s UK Equity Income sector, the average fund fell 11.29% over the three years to 1 September, although performance has come back over one year, with an average 11.37% return over the period.
The funds that topped the peer group over three years are united by several common factors, including greater-than-average small-cap exposure, having their maximum weighting in overseas earners, and a focus on diversification of dividends.
Unicorn UK Income is the best performer over three years, with a return of 9.23%, which manager John McClure says was due as much to what he held as to what he avoided.
“The fund was not invested in the FTSE at all; it was all in small and mid caps that pay a dividend,” he says.
“In the past three years in particular, we have had no problems with banks or BP, which has been a significant contributor.”
McClure also points to diversification as key to the £3.5m fund’s success, particularly in maintaining an income stream.
“We took the view a long time ago that dividends were too concentrated. We preferred to have a diversified portfolio of different stocks so we would not have problems if one did not meet its target,” he says.
He has also avoided the highest-yielding stocks in the market in favour of those that could pay a regular dividend, giving a steady income stream.
The fund has zero exposure to the FTSE 100, 21% in FTSE 250 stocks, and 38% in small caps. The remainder is split almost equally between Fledgling and Aim stocks.
Exporters
Finally, exposure to exporters has also worked well for the portfolio.
“We bought some exporters three or four years ago and they have served us well through the market cycle,” McClure says.
The £444m BlackRock UK Income fund, managed by Nick McLeod-Clarke and Adam Avigdori, has also managed to weather the vagaries of two distinct market cycles, and has increased its dividend every year over the last 25 years. Over three years it returned 4.28%, ranking it sixth in the peer group.
Avigdori says the fund’s barbell approach to capital and income is the key to its success. “On one side we can put income shares such as Shell, which people do not view as a capital growth story, but it has a good yield, and then we might have Tullow Oil, for example, on the other side, which has a small yield but good capital growth prospects as it continues to drill for oil.”
Again, avoiding the wrong stocks was as important for the fund as owning the right ones.
“We have had great success across the board, both in companies we have owned and those we have not owned,” Avigdori says. “At the sector level, we have done well in oil and gas and life insurers. Both Tullow Oil and Admiral have been great contributors to performance.”
From late 2008, just 11 stocks contributed more than 50 basis points to returns, with winners including financials and telecoms.
Discipline
Schroder Income is the second strongest performer in the sector over three years, up 8.2%. Co-managers Kevin Murphy and Nick Kirrage took over the £1.5bn fund in May as former managers Nick Purves and Ian Lance departed for RWC Partners. The new managers say it is disciplined stock selection that has led to the fund’s enviable returns, and they have no plans to tinker with this formula.
“The fund has achieved performance through a disciplined approach to buying cheap companies, as well as those with a sustainable dividend and the ability to grow that dividend,” Murphy says.
This strictness of this process means the managers will even avoid the highest-yielding company in the UK market if they feel it will be unable to grow its dividend.
“The fund has operated with this policy for some time and it will continue,” Murphy says.
As well as a sustainable dividend, valuation is also a key consideration for the pair. Murphy uses the example of BP, which fell from £3 per share to 45p following the Deepwater Horizon disaster, at which price the Schroders duo were buying when others were selling, in the view the oil major would reinstate its dividend in the future.
Long view
The managers attribute the fund’s performance against its peers to their long-term investment view.
“In 2007, profits were at all time highs, but there was a small pot of attractive investment ideas. We owned big, boring blue chips with safe, solid balance sheets – the ones where we would be protected if the environment changed. Then in 2008 and 2009 the world changed, and we saw areas which we were bad today but where balance sheets were strong and we thought future earnings would be ok.
“The portfolio changed meaningfully in 2008-2009 – we rotated into more consumer exposed areas such as banks, media, and retailers, so we outperformed. But we did have to sacrifice some income to do that, so it was hard,” Murphy says.
JOHCM UK Equity Income has been another winner over three years, delivering 2.48% over the period, ranking it seventh out of 88 peers. James Lowen, the manager of the portfolio, says some of his competitors fell down in their inability to perform in different market environments.
“We have been more pragmatic on the economic outlook than the average manager in the sector, as evidenced by us performing well over those distinct periods,” he says.
The fact that at £428m, the fund is “on the small side”, has also helped, Lowen says. He points to his peers such as Jupiter’s Tony Nutt, Artemis’ Adrian Frost, and Invesco Perpetual’s Neil Woodford, and his former colleague Tineke Frikkee at Newton, all of whom he says run the risk of their multi-billion pound funds becoming unwieldy.
Too large to perform
“I left Newton because the fund was becoming too large to perform. JOHCM Equity Income has a cap of £750m which it should reach later this year. Because there is a cap on the fund’s size, this means I am now able to run a multi-cap strategy,” he says.
“We only buy into small caps if we like the valuation, but it does add to performance. If I had more assets it would take me weeks to add to or take away from a stock. This has been a driver of performance.”
Lowen’s process is very strict on valuation, and he will always sell out of a stock completely if it falls below the FTSE All Share yield. He is also careful to maintain risk controls, adhering to a maximum overweight of 250bp against the index, and holding typically about 55 positions to remain diversified.
He also considers the leverage of stocks in relation to their valuation.
“We look at everything in a balance sheet adjusted way,” he says. “Sometimes a stock looks cheap on a P/E basis, but if you look at National Grid, for example, it is very highly leveraged which means it is actually one of the most expensive in the market.”
