Barnett, who currently runs the five crown-rated Invesco Perpetual UK Strategic Income fund and is soon to take over Neil Woodford’s multi-billion pound income portfolios when he leaves the firm, does not believe companies will be able to deliver the kind of earnings growth that their valuations require. He remains invested in defensive companies with predictable earnings streams as a result, believing more economically sensitive companies could be in for a tougher 2014.
“I would exert caution over expectations for earnings growth given the valuations I see,” he said in an exclusive interview with FE Trustnet. “To my mind, conditions aren’t as upbeat as many portray.”
“The market has had a very good run, largely driven by P/E [price/earnings] expansion. This is largely a result of quantitative easing around the world, which has driven money into all types of financial assets – not only equities, but corporate bonds, property and other areas as well.”
“We’ve seen a re-rating as a result; however, what hasn’t happened is the earnings growth that should be there to support the re-rating. Along with QE, it’s been the anticipation of earnings growth that has driven prices up, but we haven’t seen it.”
“For this reason, I think that the market as a whole looks a lot less attractive now than it did 12 months ago.”
As a result, Barnett (pictured) does not think the UK equity market is capable of delivering the kind of returns seen in 2012 and 2013, and so is urging investors to lower their expectations.
“Relatively, equities do look cheap against other asset classes, though to a lesser extent. However, the only thing that’s important is absolute value, and it’s certainly less than it was,” he explained.
Source: FE Analytics
“For the last couple of years we’ve had a great run, but I think that double-digit growth in 2014 is a bit unlikely,” Barnett added.
The manager says there are still pockets of value, namely in defensive sectors such as pharmaceuticals, tobacco, support services and non-life insurers, which are all overweights in his portfolio.
Barnett accepts that many of his favourite stocks have had a good run, but believes that these are less likely to disappoint on the earnings front than more cyclical areas.
“For me, these sectors are where the opportunities are,” he said. “From where we are, earnings growth is going to have to come through, but this year on aggregate we’ve actually seen less on aggregate and in certain areas there’s been quite a few profit warnings.”
“You’ve got to be more vigilant and focused at this point, and look at the areas that are more likely to see earnings growth.”
Barnett is particularly wary of valuations – in the context of probable earnings growth – in cyclical domestic names such as housebuilders and retailers. He believes claims that these sectors remain cheap are incorrect and thinks they are likely to stall next year.
“The valuation discrepancy nine months ago between reliable growth and cyclical growth has disappeared now,” he said.
“There is an expectation in the general market that the economy is seeing a sustainable recovery and that has encouraged more money to go into economically sensitive stocks. That gap has closed now though.”
“I don’t deny that there is better economic activity than there was, but I don’t think the recovery is necessarily as self-sustaining as many people make out. I think next year will be an interesting period of the cycle. I just don’t think earnings growth and growth in general will be as strong as a lot of people are hoping.”
Barnett thinks that market returns next year and even beyond will be made up predominantly of income rather than capital growth, as has been the case in recent years.
“We’ve had fantastic capital growth, but it could be that income makes up the bulk of capital returns,” he said.
“We bottomed out in 2009 when valuations were extremely low and since then capital growth has been at the forefront. That could all now change.”
Our data shows that the average fund in the UK Equity Income sector has returned almost 80 per cent in capital growth since December 2009 – a touch more than the FTSE All Share.
From a total return point of view, the average UK Equity Income fund has returned just over 100 per cent, meaning that capital growth has made up the vast majority of returns overall.
Capital growth performance of sector and index over 5yrs
Source: FE Analytics
FE Trustnet looked at which UK Equity Income funds have been best for capital growth in a recent study.
Barnett says the possibility of the Fed tapering quantitative easing next year is high, which presents equities with another potential headwind in 2014.
“At some point, policy has to normalise and it could be next year,” he said. “It won’t be quick, but I do think that valuations need to be judged in the context of policy settings, which are as far from normal as they ever have been.”
“May and June were a dress rehearsal and we saw what happened there, so I do think there’s a risk there.”
While equity markets have in general performed strongly in 2013, they took a tumble in the early summer, after chairman of the Fed Ben Bernanke opened up the possibility of tapering QE this year.
Performance of indices in 2013
Source: FE Analytics
Tapering has been postponed for now, but most industry commentators agree that 2014 will see a slowing down of QE in some shape or form.
“The pace could be quicker than some people think,” Barnett added.
The manager thinks concerns over “bond proxies” – defensive, dividend-paying stocks that share many of the characteristics of bonds – in a post-tapering environment have been overblown and he will not be shaking up his portfolio as a result.
He commented: “It’s understandable and a knee-jerk reaction, but ultimately I think it’s incorrect to sell out of a stock for this reason. I can understand it on a short-term basis, but not long-term.”
“What you get from equities I own that you don’t get from bonds is dividend growth, which makes them very different. If a government bond yields 3.5 per cent, that’s all you’ll ever get, but a company can grow that dividend.”
“It’s an easy argument to make, but I don’t agree with it,” he finished.
Barnett thinks interest rates are likely to stay low for some time to come, however, giving equity markets some breathing space.
The Invesco Perpetual UK Strategic Income fund has been a stellar performer in its sector in recent years, consistently outperforming its peer group and benchmark, with less volatility.
Our data shows it is a top-quartile performer over one, three, five and 10 years and is ahead of Woodford’s much larger and higher profile Invesco Perpetual Income and High Income funds over all but 10 years. However, Barnett did not start running the fund until 2006.
Performance of funds, sector and index over 5yrs
Source: FE Analytics
With an annualised volatility of 10.61 per cent over five years and a max drawdown of 14.32 per cent over five years, it also scores very highly from a risk-adjusted return point of view, and is top decile for Sharpe ratio.
Invesco Perpetual UK Strategic Income requires a minimum investment of £1,000 and has ongoing charges of 1.7 per cent, making it slightly more expensive than the Income and High Income funds. Barnett will take over the latter two portfolios in April next year.
He also runs three investment trusts, including the Perpetual Income & Growth IT.
