A solid 2012 for equities has shaken up the UK equity income sector, with a number of funds returning to form and certain high-profile names dropping down the rankings.
This comes after defensive positioning was key in 2011, with volatility picking up and investors fleeing to large-cap safety.
For the UK Equity Income peer group, this meant more mid-cap oriented funds – and those strongly biased to overseas exposure – had a tougher period but most returned to top performance tables last year.
Unicorn UK Income is the sector’s best performer over one, three and five years to 22 January, although this time last year, it had dropped to mid-table over the previous 12 months.
Manager John McClure invests in companies outside the FTSE 100 that sell specialist products and services internationally. These suffered in 2011 but led the market last year as risk appetite returned.
Top performers over 2012 included Devro, Fenner, James Halstead, Renishaw, Arbuthnot Banking, Cineworld, Pendragon and Umeco.
McClure says: “Unresolved issues related to excessive debt in developed economies and a mounting threat of social unrest within the eurozone might have led to market falls as fragile confidence eroded further.
“However, the markets’ ability to climb this so-called wall of worry indicates many current economic and financial problems are now perceived as temporary stumbling blocks rather permanent barriers to market advance.”
With his international and export focus, and limited direct exposure to the UK, McClure believes the fund is well positioned to continue delivering relative outperformance.
Chelverton’s UK Equity Income portfolio shows a similar return to form, having also dropped down the 12-month rankings at this time last year. Run by David Taylor, the fund also bypasses the FTSE 100 and focuses on the sub-£1bn bottom 10 per cent of the market.
Looking at 2012, Taylor says the year ended on a high as small and mid-caps outperformed, partly driven by falling equity risk premiums as investors questioned the attraction of bonds.
He says: “At stock level, our higher-than-average gearing to the domestic economy contributed to outperformance.
“Interestingly, there is a growing body of opinion that 2013 may see the same sort of recovery in stocks with eurozone earnings as we saw in the latter part of last year with our domestic earners.”
With that in mind, Taylor has added to holdings in Acal, Electrocomponents and RPC, all of which have substantial exposure to Europe.
Elsewhere among the sector’s top performers is yet another small and mid-cap oriented portfolio in the shape of Henderson UK Equity Income.
Yet again, manager James Henderson struggled in 2011 but his favoured manufacturing stocks and smaller companies performed at the top end of expectations last year
Henderson says: “These firms managed to control costs during a difficult environment, with those boasting competitive products succeeding in growing sales.
“In many cases, these companies have cash on balance sheets, which leaves them in a strong position to face economic uncertainty. Cash generation is also leading to dividend growth and the expectation is for this to continue because dividend cover is high.”
Over the year, Henderson bought good-quality manufacturing companies, highlighting names such as paper and packaging business DS Smith.
He notes other growth areas worthy of investment, with the aerospace industry reporting strong forward order books that stretch out many years for example.
As might be expected, funds with a more defensive bent lagged last year, with Neil Woodford’s Invesco Perpetual vehicles the highest-profile casualties after a strong 2011.
Holding to his cautious stance of recent years, he says the challenging macroeconomic environment argued for a defensive strategy in 2012 but the market disagreed.
Woodford says: “The stock market has become obsessed with prevailing extraordinary monetary policy – driven by the need to remove the near-term risk of a eurozone area default – and interpreted this as positive for a risk-on strategy.”
He notes performance of pharmaceuticals as symptomatic of the risk-on mood, with AstraZeneca underperforming despite a positive reaction to its new chief executive.
Looking forward, he sees the macro backdrop this year as arguably more difficult than in 2012.
Woodford says: “As the year unfolds, I expect the weak underlying performance of the UK economy will feature prominently as an influence on market returns, and we are happy to continue with a defensive strategy.”
This translates into more than 30 per cent of the Income fund in pharmaceuticals, with Woodford highlighting low valuations and expecting companies’ recent poor record of drug discovery to change as they focus on more targeted and innovative medicines.
Tobacco also remains a key overweight despite underperforming in 2012, with the manager citing the reliable provision of earnings and dividend growth.
Moving finally to 2012’s major return to form in the sector, Schroder Income is once again among the top performers after a difficult period.
Nick Kirrage and Kevin Murphy took over the portfolio in May 2010 and suffered in 2011 as their preference for out-of-favour companies undergoing restructuring was at odds with sentiment.
Key sector positions include consumer names and banks, with both areas outperforming last year as more traditional defensive sectors lagged.
Murphy says: “Our strategy delivers returns from two sources: most obviously, the income companies generate but also, and equally importantly, capital returns from lowly valued companies improving.
“Take housebuilder Taylor Wimpey – because its valuation was modest, the share has more than doubled since 2011 despite the housing market remaining depressed. It also reinstated its dividend in summer 2012, but a large proportion of capital growth took place before the company returned to the dividend register.”
Murphy says some income investors are reluctant to buy businesses until dividends are assured, by which point much of the money-making opportunity is lost.
He says: “The market is not keen on a high street retailers at present due to the cyclical and structural challenges they face.
“For our part, we contend that share prices discount a fair amount of bad news and assign a low probability to companies’ situations improving.”
In recent months, the fund benefited from its holding in Dixons Retail, as the share price reacted positively to Comet’s demise.
Murphy says: “Comet’s collapse is an example of ‘free options’ value investors can benefit from when they invest in lowly priced businesses.”