IFA Magazine has been asking the experts
Yes, the strength of the UK stock market since this summer’s EU referendum has been raising eyebrows in some quarters, considering the scale of the uncertainties that abound on the world stage. But we do need to remember that UK equities remain a core component of many – if not most – investment portfolios.
So, with the weakness of sterling providing a major boost to the value of shares in exporters, what are the challenges for advisers and investment managers as they look to maximise the opportunities and avoid key risks for 2017 and beyond when considering UK equity exposure?
Both sides of the situation
We spoke to two leading asset managers – Standard Life Investments and Old Mutual Global Investors – to find out where they see the biggest risks and opportunities in the UK equity sector. And then we talked to two leading advisory firms to get their views on the sector – and, essentially, to find out which funds and which fund managers they are favouring at the moment, and why.
1. “UK Equities – risk and opportunity” – Standard Life
Thomas Moore, UK Equities Portfolio Manager at Standard Life Investments, says that while the FTSE 100 is breaking records, there are opportunities to be found among smaller and mid-sized UK companies for those who are willing to look for them…
In practice, says Moore, many of the FTSE 100’s constituents – which make much of their earnings overseas – have countered post-Brexit pessimism quite effectively on the back of strengthening commodity prices, and on the fact that sterling has hit a three-decade low.
But, we asked, is this a long-term, sustainable shift in fortunes for the dollar-earning mega-caps of the FTSE 100? There are some strong indications that sentiment toward some sectors may now be approaching extreme levels. As such, he says, his team believes that a sizeable opportunity has now appeared for those advisers and investors who are willing to stay focused on company-specific fundamentals, including smaller and mid-sized stocks.
There are a few things UK equity investors must pay attention to amid the uncertain political backdrop. First, says Moore, the gap between equity dividend yields and bond yields has widened to record levels. This in turn reflects anxiety regarding the reliability of corporate earnings and dividends amid the post-Brexit backdrop.
Second, he says, UK sector valuations are currently polarised and poised to snap back, because macro-driven moves in bond yields and currencies have led to some extreme disparities in sector valuations. The gap between cyclical and defensive valuations, according to Moore, is even higher than it was during the financial crisis of 2008-09. Low bond yields have pushed investors into sectors such as consumer staples, which now trade on p/e valuations of 20x with a 2-3% dividend yield, despite having only pedestrian organic growth rates.
And yet, he says, some investors continue to believe in the ‘greater fool’ theory – relying on being able to sell their overvalued stocks at an even higher valuation in the future. Up to now, this approach has worked well, supported by QE. Could there be a trigger for this strategy to backfire?
Taking a blanket view on UK stocks might be tempting, says Moore, but that strategy misses out on many important opportunities. In practice, investors willing to scour the market will find many UK stocks that offer the prospect of sustained dividend growth thanks to a fundamentally healthy dividend cover combined with low debt levels.
For the moment, too, post-Brexit economic data remains buoyant for the UK. And so do consumer sentiment and household cashflows, which currently look set to hold up despite the weak pound. As we’ve noted in this month’s IFA Magazine news section, wage growth and lower interest payments have been combining to offset higher import prices. And against this backdrop, domestic cyclicals and financials look ripe for a recovery.
There’s good news and bad news in the way that many large-cap stocks on the FTSE rallied sharply after the EU referendum – largely due to increased risk aversion. However, says Moore, Standard Life believes that these companies are now significantly over-valued in relation to their weak earnings and dividend prospects. And a correction could therefore be forthcoming.
Further afield, Moore notes, global markets which also reacted negatively to the UK vote have now largely recovered, “with investors viewing the event as a local rather than a worldwide headwind. Overseas equities have been further supported by an improving US economy and, in the likes of Japan, China and Europe, supportive monetary policy.”
While markets may remain volatile during forthcoming UK-EU negotiations, he adds, the UK equity market appears to be at an extreme in terms of macro-driven positioning – creating opportunities for bottom-up investors who are willing to stay focused on company-specific fundamentals.
“We continue to use our extensive research resource and Focus on Change investment process to identify companies with sustainable dividend growth, and where attractive dividend yield is backed by cashflow momentum, dividend cover and balance sheet strength. We remain confident that this approach will deliver superior growth in capital and income over the medium term.“
2. “Waiting for the fiscal stimulus” – Old Mutual Global Investors
A possible announcement in the forthcoming Autumn Statement [due on 32rd November] about an increased fiscal stimulus ought to benefit the majority of the Old Mutual UK Alpha Fund’s holdings, explains Richard Buxton, head of UK equities and the fund’s manager.
“Has anyone else noticed it? I am, of course, referring to the beginnings of a change in mood music for the UK equity market. We may have been here before, where time has been called on the near 30-year bull run in bond markets, resulting in yields grinding gently upwards, only to be compressed once more. But let me explain why, this time round, I believe things are different…
“I am becoming increasingly convinced that monetary policy, in all of its guises, has reached the end of its useful life. Negative interest rates may help companies to borrow cheaply, but if the money is used for share buybacks or overseas acquisitions that merely exacerbates the divisive nature of Quantitative Easing. It boosts asset prices for those who own them but the vote to leave the European Union was, in part, a warning shot across the bows of institutions from Joe Public flagging that not enough has been done to help those in the ‘real’ economy who aren’t rich in assets.”
Changing the mood music
“What is to be done? The smart money is on the use of fiscal stimulus. Hopes are rising that, come the Autumn Statement, Chancellor Hammond will announce major spending plans for boosting Britain’s network of roads, railways and a myriad of other things. This, surely, will alleviate some of the pain and economic uncertainty of a ‘hard’ Brexit?
“Of course, this change in the mood music may be played out over many years but if the baton finally passes from monetary to fiscal stimulus, it has significant implications for leadership in equity and bond markets. The aforementioned infrastructure projects will need to be financed somehow.
“The most obvious way would be a massive sale of billions of pounds worth of UK Gilts, flooding the market and, at long last, depressing bond prices and lifting yields in the process. Rising bond yields would be good news for a number of reasons, not least helping to restore much needed profitability to our unloved banking system through an improvement in banking margins.
Bond proxies – where now?
“A further consequence could be the negative impact on ‘bond proxy’ stocks, the likes of which have become way too overcrowded a trade in my view, particularly in the consumer staples sector. Investors might finally wake up to the realisation that Barclays Bank, which trades on a 50% discount to book value, isn’t that bad value compared to British American Tobacco, which sits on a 12x price/earnings multiple… for 2020.
“Given increased government borrowings, the pound will have to continue to take the strain. But that is not all bad news for the 75% or so UK-listed companies with large overseas earnings which are listed on the FTSE 100 index. Does this mean, at long last, larger companies might even unwind years of outperformance registered by their smaller and medium-sized peers?
“The market moving events which investors face in the final months of the year – the Autumn Statement, a bitterly contested US election and an Italian referendum which could see a further rise in populist parties – means investors will need to be confident of their respective fund positioning.”
3.“Don’t forget dividends” – Whitechurch Securities:
Ben Willis, Head of Research at Whitechurch Securities, is keen to remind us that looking for a solid income stream is still important under current market conditions
“It seems hard to believe that since the UK’s momentous decision to leave the European Union this summer, we would see UK stockmarkets currently trading near record highs. While this rally has provided some relief given the immediate concerns post-referendum, the outlook for the UK economy remains unclear. Only time will tell what ‘Brexit’ actually looks like.
“Since the vote, UK large cap global businesses have been the big winners, benefiting from sterling weakness as these companies generate overseas earnings in US dollars. In addition, the Bank of England’s recent interest rate cut and gilt purchase programme has squeezed deposit rates and bond yields further. This has only increased demand for dividend-paying UK blue chip companies.
“Currently there are lots of FTSE 100 stocks paying attractive dividends, but dividend cover remains a problem. With many large caps facing issues such as increasing pension deficits and historically low commodity prices, dividend cover is likely to remain an issue going forwards.
“Income stalwarts such as BP and Shell continue to pay attractive dividends over 5%, but dividend coverage is low, and the ability to keep paying a dividend in the future with oil prices at current levels is in question.
The value of dividends
“Given the strong performance of the FTSE 100 since the referendum, can it continue? Well, the recent interest rate cut only reinforces our view for seeking out dividend paying stocks. In the present uncertain climate it makes sense to hold dividend paying companies across the whole market spectru – ranging from overseas earners who are benefiting from sterling weakness to domestic, quality businesses that can grow dividends despite the economic backdrop.”
Two funds that Whitechurch has successfully invested in since their initial launch are Woodford Equity Income and Miton UK Multi-Cap Income, he says. “Both funds benefit immensely from having highly experienced UK equity fund managers at the helm that have established strong, long-term track records.”
“The eponymous Woodford Equity Income is managed by the highly regarded Neil Woodford, who established his reputation at Invesco Perpetual. Woodford’s approach is to take a contrarian, top-down view, often making large sector bets – for instance, no oil majors and no banks. He is also a keen investor in unquoted businesses and will allocate a limited amount of the fund towards this area in order to generate potential for capital growth.
The Miton fund is distinctly different, he says. Although the fund is free to invest in large companies, its predominant focus is on smaller UK dividend-paying companies. Managed by Gervais Williams -formerly at Gartmore and Henderson, and a proven smaller company investor – Williams aims to focus on higher-quality smaller-sized companies which he believes can grow their dividends over time.
Both funds complement each other well, says Willis – seeking equity income opportunities from differing areas and industries. And by holding a blend of both funds, investors can achieve diverse exposure across the board to UK stockmarkets.
4. “Best of Breed” – Investment Quorum
Not all UK equity investments are the same, says Peter Lowman, Chief Investment Officer at boutique wealth manager Investment Quorum.
“When constructing a well balanced portfolio, deciding upon the right mix between large, mid and small caps, special situations, recovery stocks, contrarian fund managers and of course UK equity income funds, is incredibly important for advisers and investment managers, especially at the moment.”
Currently there are nearly 400 UK funds facing advisers and investors, he says, including 270 in the UK All-Companies sector, a further 80 in UK equity income funds, and 47 in UK smaller companies. And that’s not including investment trusts and exchange traded funds.
And yet, says Lowman, a great many of these funds deliver only a “consistently average performance,” which he says leaves us with what IQ regards as the “best of breed funds”: the ones that have “experienced fund managers at the helm, [have] shown consistent performances, and can demonstrate a constructive investment process.”
Fund managers with a solid investment process
Nobody’s disputing that there are many risks within the current market, says Lowman. But “the sensible strategy for advisers is to avoid the daily noise and concentrate on those best-of-breed funds which tend to perform in all weather conditions- thus giving your clients meaningful, risk-adjusted returns for the long term. “
Investment Quorum’s nominations, he says, would include funds such as Lindsell Train’s UK Equity Fund, managed by the amazing Nick Train whose Buffettology approach has delivered consistent performance over many years. Another, he says, is the LionTrust Special Situations Fund, under the stewardship of Anthony Cross and Julian Fosh, whose objective is to deliver long-term capital growth through pure stock picking.
The long and the short of it
Others to mention, he says, are Ardevora UK Equity Fund managed by Jeremy Lang and William Pattisson, whose approach, he says, is to recognise stocks that perhaps the market has wrongly priced. It’s worth noting that this fund has a mandate to go long, or short when positioning the fund, which hopefully gives investor benefits from both rising and falling markets.
Then, finally, he says, there’s the Franklin Templeton UK Managers Focus Fund, whose team approach helps to construct a concentrated portfolio of their best ideas that cover large, mid, small and income stocks to deliver a combination of both growth and income. Not forgetting the estimable Evenlode Income fund, managed by the well-respected Huge Yarrow and Ben Peters.