UK Equity Income has always been a popular sector, but never more so than in current market conditions, with investors desperate for that extra injection of income.
According to the IMA, the UK Equity Income sector saw inflows of £27.1m to January 2012 – the fourth most popular equity sector that month. With total funds under management of £54.6bn, it is the second most popular sector, sitting just behind the IMA UK All Companies sector, which has more than £96bn invested in it.
It is easy to see why investors have been fleeing to the sector, as not only are most UK equity income stocks global – so less affected by what’s going on in the UK and Europe – but companies in the FTSE 100 have been increasing their dividends.
For example, the board of Vodafone, one of the largest FTSE 100 stocks, in November agreed an interim dividend of 3.05 pence per share, an increase of 7 per cent year-on-year, in line with a target to grow its dividend per share by at least 7 per cent a year until March 2013.
However, there have been claims that the market is too concentrated, with a lot of managers holding the same stocks as they pay such a gigantic proportion of the FTSE 100’s income. When something goes wrong with one of those stocks, it can hit all UK Equity Income funds hard, as proved by the BP oil spill in 2010, which saw the company halt its dividend payments altogether.
This is where it pays to look for managers who can broaden their portfolios away from the major dividend payers.
“Historically, there’s been a long and well known concentration of income in the FTSE 100. Everyone’s known about it, everyone can talk about it, but until the BP incident no one did anything about it,” argues Ben Seager-Scott, senior research analyst at Bestinvest.
“You’d look at most managers’ top 10 and would see the same companies – BP, Shell, HSBC, GlaxoSmithKline, and Vodafone. Since then a lot of managers have woken up to this idea [that] concentration is a risk. BP has brought home the idea that adding diversification of those key holdings is good. We’re increasingly seeing quite a lot of managers taking ex-UK positions.”
Defensive diversity
Invesco Perpetual’s star income manager Neil Woodford is a prime example. Mr Woodford maintains a diversified portfolio by investing in overseas stocks as well as global pharmaceutical and tobacco names.
In the five years in the run up to the Lehman Brothers crash, Mr Woodford’s High Income fund returned 93.09 per cent, making him top of his peer group.
However, Meera Patel, senior analyst at Hargreaves Landsdown argues: “Neil Woodford has obviously done very well over that time period, but going forward you have to look at it from a few different angles. If an investor thinks it’s going to be all doom and gloom for the next 3-5 years then in all cases, stick with [Mr] Woodford, as his fund is more defensively positioned in larger, more resilient stocks. Alternatively, there’s also the Troy Trojan Income fund, which is equally as defensive.
“But for those that think that we may see proper resolution to the European debt crisis in the near future – and we have started to see signs of this, with economic data in the US picking up – then it’s better to have a balance of both a conservative/cautious play as well as something like the JOHCM UK Equity Income fund, which is pro cyclical and not afraid to look at companies which have fallen on hard times and could be re-rated and in an environment of recovery could do very well.”
Smaller opportunities
If this does happen, then other funds that could benefit from a recovery are the Unicorn UK Income and Axa Framlington Equity Income, which both lean towards smaller companies.
Mr Seager-Scott says: “The Unicorn fund is interesting. I’m not sure if I’d expect them to do well or badly going forward, but what I would say is they’re very heavy in small cap, which is why you often see them either at the top or the bottom.”
In the five years since the Lehman crash, the Unicorn UK Income fund has outperformed its peers, returning 77.28 per cent.
The Axa fund, run by George Luckraft, on the other hand has underperformed in the same time period, sitting 80th amongst its peers.
Mr Seager Scott argues: “George Luckraft has had a tough time of it lately. The manager uses a ‘barbell’ approach which combines ‘slow and steady’ high yield stocks – often large, mature companies with relatively limited growth prospects – with lower yielding stocks that have strong growth prospects, and are typically at the smaller end of the investment universe.
“The bias towards smaller companies hurt the relative performance of the fund when markets fell sharply in 2008-09 but missed out on the subsequent bounce in the relief rally of 2009. The large-cap stocks provide an element of ballast to the fund, but it seems to me that the manager’s stockpicking in the small and mid-cap space hasn’t been working out for him against the tumultuous investment backdrop.”
Defending his performance, Mr Luckraft states: “I underperformed last year because small caps did very badly and 2008 was horrendous – I was wrong. I didn’t ever envisage the economy being as bad as it was post-Lehmans, as I wasn’t expecting the authorities to let Lehmans go, so I was caught horribly.
“Also, I had to handle [the fact] that the fund had expanded rapidly and I had redemptions to handle throughout 2008 and 2009, so I wanted to make sure I came out of that process with a portfolio which wasn’t just small caps but had some FTSE 100 content. Inevitably there was a lack of new ideas going into the portfolio because I was handling redemptions, so it got a bit stale in that respect and didn’t help going forward.”
Ms Patel says the manager can still outperform.
“We haven’t given up on him yet, but when small caps start to perform better then I’d expect him to make a rapid turnaround. If he didn’t then that would raise further question marks.”
Mr Seager-Scott, on the other hand, adds: “The outlook doesn’t look any less challenging, giving me little hope that the manager’s fortunes will come back around.”
A third way
Leaving aside portfolios with biases to more vulnerable smaller companies or the safer large caps, third-way recommendations from Ms Patel and Mr Seager-Scott for the next five years include the Threadneedle UK Equity Income and the Trojan Income funds.
On the former, Mr Seager-Scott says: “They have the right blend between top down [macroeconomic calls] and bottom-up stockpicking. In this area it helps to have a good macroeconomic view and not purely look at companies in isolation, as in all times the macro will impact all stocks.”
According to Richard Colwell co-manager of the Threadneedle UK Equity Income fund, the vehicle remains overweight industrials, with a focus on quality, self-help companies with strong balance sheets, such as BAE Systems and Wolseley, and economically sensitive consumer stocks, where valuations may be excessively discounted off the back of the poor outlook for the domestic economy – examples include M&S and ITV.
Mr Seager Scott also likes Artemis managers Adrian Frost and Adrian Gosden because of their heavily analytical approach to companies’ cash flow.
“They’re a lot more methodical in their process, almost more like the way you’d analyse bonds. They look at free cash flow, and the managers have a strong accountancy background, so they’re very good at drilling into what’s really going on at a company and properly interrogating those fundamentals. It means you don’t get carried away – you want that income, but you want it to be sustainable, not just ones that might look attractive on a yield basis, but then get stuck in a value trap,” he adds.
However, although investors continue to see opportunities in UK equity income funds, returns have not been as good as they were pre-Lehman Brothers. The average return in the sector in the five years run up to the bank’s collapse was 42.83 per cent, yet in the five years since it has dropped to 23.31 per cent.
“In spite of recent market improvements, we expect a year of modest returns from UK equities as slowing growth or outright recession limits growth in corporate profits and risk aversion constrains the valuation of the market,” says Mr Colwell.
“However there is still scope for attractive, above inflation dividend increases in large parts of the market where balance sheets are strong and capital demands are modest. Yield will, therefore, be increasingly recognised as a key component of the returns accruing to equity investors and may even provide the majority of their returns. UK dividends are well covered, [with companies’ deployable cashflow] at 2.4 times [their annual dividend payments], and forecast to grow by up to 10 per cent in 2012.”
Simona Stankovska is features writer at Investment Adviser
