This week’s Conjecture panel discuss the prospects for the UK Equity Income sector
With many managers now believing the worst is over for dividend cuts in UK Equity Income markets, Investment Week gathered together a panel of experts to discuss the prospects for this sector. This week’s Conjecture panel consisted of Threadneedle’s Jonathan Barber, Neptune’s Alex Breese, and Peter Fuller from Standard & Poor’s.
What has your fund done in the last three to six months and how are you positioned?
Jonathan Barber (JB): Over the last three to six months, my fund, which is a Threadneedle UK Monthly Income fund, has performed in line or slightly ahead of the income fund peer group.
Obviously, the peer group has done very badly. I always think we should look at UK Equity Income funds versus probably the UK All Companies sector, because that is really the clearest direct comparison.
For example, over three years, the average All Companies fund is down about 9% and the average UK Equity Income fund is down about 14%.
So clearly it has been pretty poor. Probably the main reason it has been so bad is in the recession we have just emerged from; for the first time we have actually seen aggregate dividends paid out when UK companies fall.
Whereas if you looked at the last three recessions, you will see in each of those dividends income actually rose.
Income has been a very poor proxy for value over the last couple of years. We all know about bank dividend cuts and insurance company dividend cuts.
That is why it has been bad.
We can be, potentially, slightly more positive now because if we want to be contrarian, then obviously this is potentially a good opportunity to buy into income funds.
And we feel dividend cuts are effectively played out now and the income base of the UK equity market is now looking pretty resilient going forwards. For those two reasons, I think the sector looks a bit more interesting going forwards.
Alex Breese (AB): Over the last 12 months it has been quite a difficult period for an income fund. Mainly because last year we did see a post-March strong rally in the more cyclical stocks, the most beaten up stocks and probably I think it is fair enough to say the lower-quality stocks in the market. Our Income fund really does focus on quality and buying into good business franchises with strong balance sheets.
Those kind of companies performed much better throughout the bear market, but last year it was clear a lot of people were selling those high-quality names to fund purchases in more cyclical lower-quality stocks. In that kind of environment, we would not expect to outperform. And certainly for the year, performance of the fund was in line with the peer group but behind the FTSE All Share total return.
It is worth noting we had a very good fourth quarter of the year and we think the market has started to shift its focus back towards high-quality stocks.
In an environment like last year where dividends were being cut, it would always be difficult for the income sector. But even in that environment, we grew our dividend 13% in 2009 over 2008.
To put this general sector performance into some context, UK Equity Income returned 0.6% over the last three months and UK All Companies returned 0.3% over the last three months.
On a 12-month basis, the average fund in the Equity Income sector returned 33% and All Companies returned 39%.
Standard & Poor’s has collated some of the feedback it got from a questionnaire as to where managers are positioned in this part of the market. Peter, can you talk us through some of the findings?
Peter Fuller (PF): The snapshot survey went out the week before last, so it is pretty up to date.
One key issue is increasing confidence among the Equity Income fund managers. They see a definite shift in the market from the fourth quarter 2009 and have moved from recovery plays and balance-sheet restructuring, to higher-quality stocks on solid fundamentals.
So, a general shift from trading to a traditional fund management style, which I think is definitely beneficial to equity income managers. There seems to be a bit of a barbell between the more defensive sectors and the cyclicals.
Certainly more use of the 20% offshore, or off benchmark allowance, but mainly in substitute positions.
So instead of Vodafone, they get Telefonica, or even Brazil’s Telemar. And exposure to mid caps is slightly up, which surprised us. But very stock-specific and focused on quality.
Where are you are looking for ideas in the markets? Are there any restrictions you have for the portfolio within market-cap size? Are you making any use of the international exposure?
AB: First of all it is worth noting we have a unique way of managing the fund – we only hold 33 stocks in the portfolio, so it is very much a high-conviction fund. We have 3% per holding, so it is an equally weighted portfolio, and we can invest up to 20% overseas, which gives us the opportunity to have six overseas companies at the 3% level each.
We are currently using 15% of that allowance, so we have five overseas holdings in sectors where we want to be overweight. For example, there is a handful of large-cap UK pharmaceutical companies to choose from, but we also hold two additional yield-generating overseas companies in the sector.
In terms of the split between the FTSE 100 and the 250, we are actually very much biased towards the 100, with its more liquid and high-quality stocks generally. Also, they tend to have higher overseas exposure, which is a theme we are looking for in the portfolio. We have only 12% of the portfolio in the mid-cap space at the moment.
JB: We have always taken the view, rightly or wrongly, that our expertise very much lies in the UK. So while we reserve the opportunity to invest overseas in the last six or seven years, we have very much concentrated just on UK stocks, because that is where we think we can really add value.
In terms of the shape of the portfolio at the moment, I have got about 70% of the fund in the FTSE, about 25% in mid caps and about 5% in small caps.
Given what we see as the much better prospects typically for overseas economies versus the UK economy, we are very much focused away from UK domestic stocks. We are weighted much more towards overseas international earners, where we think the sort of premiums you pay for the much better growth prospects are really quite modest in practice.
How are you valuing the market at the moment? Does it feel like fair value, cheap or maybe a little bit expensive, perhaps relative to some of the other international markets?
AB: The market is certainly nowhere near as cheap as it was in March and April last year. And that was an extreme valuation anomaly – it is very rare you see such a good opportunity to buy the market on such cheap valuations. So the UK has gone from a P/E ratio of just below seven times earnings to about 12 times today, which is still below its average level. If you look at cyclically adjusted earnings – so 10-year average earnings – the market looks even better value.
The market still has reasonably good value in it at the moment generally, and there are pockets of very good value in some of the more defensive sectors, which again is good for income funds.
JB: Relative to history, it still looks slightly on the cheap side, despite the rise we have seen over the last 12 months or so.
We would also make the point that this year you are still seeing losses or sub-trend profits from financials.
So if you strip that out, then the market probably looks maybe a point and a half cheaper than the headline numbers suggest.
The rise in the market last year was very indiscriminate in some respects. When we sift through we are finding plenty of value opportunities throughout the market.
PF: If we look at the valuations relative to opportunities abroad, in that sector there certainly is. BP, Shell and HSBC are UK companies paying dividends in dollars. Taiwan Semiconductor is a global company that pays in dollars as are Nintendo and Novartis.
There is far more opportunity now you can use substitute companies and this is definitely a growing trend, and I cannot see it turning round. In Asia particularly, there are plenty of companies where there is the beginning of a culture of paying income, so you are not looking for income now – you are looking for income stream.
