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Defensive pays off for UK equity income

James Smith looks at the UK equity income market, which remains a safety-first environment delivering sustainable dividends and long-term growth.

The one-year performance figures for UK equity income funds show normal business has resumed, with Invesco Perpetual’s Neil Woodford back on top after a 2009/10 dip.

The change from stock-market growth in the first three months of last year to sharp falls as the economic outlook deteriorated, resulted in Woodford and other defensively minded peers moving back to head the rankings as volatility picked up and investors fled to large-cap safety.

In contrast, several of the portfolios still leading the sector over three years, Unicorn UK income and Chelverton UK equity income, for example, suffered in 2011 as mid-caps struggled and overseas exposure was no longer seen as all positive.

Looking at Woodford, he has spent much of the last couple of years outlining his cautious view and justifying defensive exposure on his funds, which underperformed in the post-credit crunch recovery.

July to September last year saw the worst FTSE All-share index performance since the third quarter of 2002, and this defensive positioning was clearly beneficial as Woodford’s fund only fell by a third as much as the market over a torrid three months.

Woodford says his defensive holdings have held up well due to dependable qualities and cash generation, with tobacco and pharmaceutical stocks particularly positive.

A zero weighting to mining stocks also proved beneficial as many fell sharply in response to reduced forecasts for global growth and concerns about a hard landing in China.

Woodford says: “The increasingly tough economic outlook is not a surprise to us. We maintain our view that the developed world faces a prolonged period of low economic growth and the fund is positioned accordingly.

“We believe there are certain types of companies that can thrive in this environment, delivering sustainable dividends and earnings’ growth. The market sell-off left many of these strongly placed companies looking even more attractive and we remain confident about the outlook for long-term returns.”

The Troy Trojan income fund, run by Francis Brooke, is heading the sector over 12 months and has also been buoyed by its quality-driven defensive approach.

Favoured holdings are typically stable or growing companies with differentiated products or services and a strong balance sheet that can support a growing dividend stream throughout the cycle.

Income veteran Psigma’s Bill Mott has also climbed the sector over the past 12 months. Mott is another long-term advocate of defensives and says volatility in recent months has offered up opportunities to enter stocks such as Renishaw, bought at less than half the price of six months earlier.

With much of 2010 characterised by a risk-on, risk-off trade in equity markets, and investors chasing the next earnings upgrade among miners, Mott says this left the ignored defensive part of the market looking outstanding value.

Mott says: “Within our central case of anaemic global growth, we are excited that there are still so many companies across diverse sectors offering well covered dividends, yielding two or three times that of medium-dated gilts.

“Uniquely, this yield is not from companies most at risk in a downturn but available in large multinationals that have strong balance sheets and good pricing power. These are exactly the companies we would want to own in the current environment and, with these yields, we are being paid to do so.”

More than 90 per cent of the PSigma income fund is in large-cap stocks, with Mott steering clear of smaller companies with their attendant higher-risk profiles.
In recent turmoil, the manager took advantage of sharp falls in the mining sector to raise commodity exposure.

Mott says: “From near zero, our weighting is now 2.5 per cent, with Rio Tinto and BHP Billiton added to the holding in African Barrick Gold. “We are taking small steps and must emphasise this does not signal a change in view. It is simply a recognition of the recent dislocations in share prices.”

In mid-2011, Unicorn UK income fund was the best-performing UK equity income fund over one, three and five years but it has subsequently dropped to a mid-table position over 12 months. Manager John McClure looks to invest in companies with a strong international presence and a bias towards industrial product and business service markets.

These investments outperformed as emerging markets boomed and the developed world recovered but they have taken a hit in the safety-first environment that came to the fore last year.

McClure’s changed fortunes are clear from deteriorating stocks in his portfolio. In early 2011, for example, he highlighted Acal, a distributor of specialist electronic components as one of his strongest holdings, whereas in November alone, the stock plummeted by 20 per cent.

McClure says: “Acal’s share price fell throughout the month in anticipation of reduced growth prospects following extended turmoil in its key European markets.”

With the Chelverton UK equity income fund seeking yield from small and mid-cap stocks, its decline from second in the peer group over three years to third-quartile for 12 months is little surprise. The portfolio bypasses the traditional income stalwarts of the FTSE 100 and focuses on the bottom 10 per cent of the market made up of companies worth less than £1bn.

Manager David Taylor’s approach is to filter out any stocks not yielding at least 50 per cent more than the small-cap benchmark.

Marking the fund out from its peers, this largely excludes small oils and miners for their lack of yield, as well as banks and pharmaceuticals, with few smaller players in either sector.

Taylor says: “Our favoured stocks tend to be seen as dull but worthy and are generally undervalued. Our main competition for these companies would be other small-cap funds but most tend to focus on growth- type opportunities, so our stocks remain cheap.”

In recent times, the portfolio’s biggest sector exposure has been to support services, with decent positions in insurance companies as well as engineering firms.
Taylor said many companies he is looking at have displayed strong balance sheets and increased dividends but have suffered in the widespread risk-aversion last year.

“As we move into 2012, consensus earnings per share growth for the UK equity market is forecast to be around 10 per cent, although, in aggregate, estimates are still falling, particularly for some cyclicals.

“Current consensus estimates suggest an earnings multiple of under 10 times, which means there is scope for multiple expansion when the balance of earnings’ upgrades to downgrades turns positive. Importantly for our fund, we expect dividend growth will remain strong throughout.”


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