Colwell (pictured) and Harrison’s £2.2bn portfolio has been one of the very best funds in the sector over the last three years, and the managers say their success comes from buying stocks when they are out of favour.
They are sceptical about the idea of a UK recovery and are not chasing the market into areas that are becoming more expensive on the back of the rally. "Quite a lot of the improvement [in the economy] may be a function of the last bout of QE [quantitative easing] Mervyn King left us with last year – it generally has a year lag, so we will need to see what happens next year to see if there’s any real momentum," Harrison said.
Harrison and Colwell refuse to take a view on the macro-economic future and are retaining a portfolio built for different outcomes. They are sceptical that a corner has been turned, however, given the amount of debt the world is still struggling under.
The banking system in Europe still has serious problems that will weigh on markets, they warn.
Bank balance sheets are still too large, which is putting deflationary pressures on the economy that the managers expect to remain for some time.
While policy makers will likely do anything to avoid a 1994-style double crash in bonds and equities, they are doubtful that the prognosis is as good as some people think.
They also express scepticism about the Government’s policy of inflating the housing market, saying that the UK consumer doesn’t need to take on more debt.
As a result, they are looking more to some contrarian stocks that have been left behind in the rally, such as Imperial Tobacco.
Imperial Tobacco is a staple of equity income funds, but the managers were less keen on it when it was in favour by the market.
The development of the e-cigarette caused a number of analysts to produce some very bearish notes on the sector, but it was a signal for Harrison and Colwell to buy.
Performance of stock vs index in 2013
Source: FE Analytics
They are also buying more of Marks & Spencer, which has been a whipping boy for the equity analysts in recent years, the managers explain.
While the market is waiting for the company to show improvement in clothes sales, the Threadneedle fund is enjoying the benefit of improving food sales.
"If you were to wait for clothing sales to pick up, you would be too late," Colwell said.
Despite the negativity on the market, Marks & Spencer has risen 33.62 per cent in 2013, well ahead of the FTSE. The managers say they bought the stock at around 350p and it is now trading near to 500p.
Performance of stock vs index in 2013
Source: FE Analytics
Another out-of-favour retailer the team is backing is supermarket group Morrisons.
"They have had a good couple of years in what’s clearly been a tough market for them; everybody is obsessed about the thought of internet shopping," Colwell said.
The stock has lagged the FTSE year-to-date with returns of just 11.38 per cent. It is one of the most shorted by institutional investors, as FE Trustnet revealed in a recent article.
The fund is also hanging on to its exposure to stocks in the defence sector.
"This time last year when everybody was worried about the possible sequestering and the defence budget being cut we bought Cobham, BAE and Smiths Group," Colwell said.
All three stocks have significantly outperformed the FTSE over the last 12 months, according to data from FE Analytics.
Performance of stocks vs index over 1yr
Source: FE Analytics
"Cobham has clear strategies where they can exploit pockets of growth in the US market," Colwell said.
The managers also bought more of insurers Aviva and RSA after their dividend cuts earlier this year saw investors desert them.
A few years back they bought into ITV and Reed Elsevier when they were unloved.
The managers say that they buy a mixture of stocks with decent yields and dividend growth, so are willing to buy companies that currently yield less than the market if they see the potential for their payout to improve.
In total, 42 per cent of the companies in their portfolio yield less than the FTSE, although the fund as a whole is yielding 3.7 per cent on its figures, 10 to 15 per cent above the market.
The managers say they have no intention of following the market back into banks. Harrison started his career at the Bank of England and Colwell is a former banking sector analyst and the managers say they understand the sector well.
It is not a must-have for equity income investors, they claim, and in fact back in the 1980s regularly traded at below book value and the banks were considered "value destroyers".
None of the UK retail banks currently look attractive, the managers say, and they do not regret missing out on the gains in the sector.
Harrison took over Threadneedle UK Equity Income in 2006 and Colwell joined him in 2010.
Over five years the fund is marginally ahead of the sector and benchmark, in the second quartile.
Over three years it is first quartile with returns of 51.5 per cent to the sector’s 39 per cent.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
Over the past year the fund is second-quartile, with returns of 28.4 per cent to the sector’s 24.93 per cent.
The fund is available with a minimum initial investment of £2,000 and has ongoing charges of 1.62 per cent.
