The strong performance of the UK stock market has been driven on the whole by small and mid-caps, and the bottom half of the FTSE 100.
The strong run has led many to question how much value is left in the best performing areas, leading an increasing number of fund managers to up their exposure to blue chips – particularly those focusing on UK Equity Income, as many of the large caps laggards pay dividends.
A good example is Threadneedle’s Richard Colwell (pictured), who holds a number of lagging large caps across his range of UK equity income portfolios. “Post the financial crisis there were great opportunities to buy more cyclical stocks at trough multiples of trough earnings. The valuation opportunity has now shifted to higher yielding large cap laggards,” said Colwell, who runs a number of income-focused funds including Threadneedle UK Equity Income.
“Having not been overloaded in that space previously, we have been able to use strong steady inflows into the UK Equity Income fund to take advantage of the valuation opportunity and add to stocks in that space.”
Here are four of the companies Colwell is particularly optimistic about:
Marks & Spencer
Colwell says that the general retailer has suffered recently from ongoing negative like-for-like sales in its general merchandise business. FE data shows that it is down against the FTSE 100 over the past six months, losing 8.78 per cent in the process, though performance has been much better year-to-date.
Performance of stock versus index over 6 months
Source: FE Analytics
Colwell says the sell-off has presented investors with an opportunity, and is using the fall to add his exposure to the stock.
“This is a self-help story, with opportunities to improve competitive position, win back market share and increase margins,” he said.
“More generally it is showing signs of recovering from years of underinvesting, with progress made on investment in logistics, online and general merchandise.”
“There is a positive outlook for cash flow and it is supported by an attractive yield of 3.75 per cent, with scope for sustainable dividend growth.”
Marks & Spencer is currently on a forward price-to-earnings [P/E] ratio of 15 times, and is a top-10 holding in Colwell’s Threadneedle UK Equity Income fund.
Royal Dutch Shell
Shell has long been a popular stock with income investors, but share price performance for much of 2013 was weak.
Performance of stock versus index over 3yrs
Source: FE Analytics
Again, Colwell has been using this weakness as an opportunity.
“Shell should see the benefits over the next few years thanks to its heavy capex,” the manager said.
He says 2014 will be a year of change for Shell, with the company moderating capex and putting more of a focus on capital efficiency and cash flows.
“The market is now starting to accept the restructuring story, seeing that oil majors are embracing capital discipline. This will bring stability to the share price,” he added.
Colwell says he expects cash flow to improve, and sees a forward P/E ratio of 10 times and a dividend yield of 5 per cent as very attractive from a valuation point of view. Shell has a 2.9 per cent weighting in Threadneedle UK Growth & Income, making it a top-10 holding.
AstraZeneca
“This large cap global pharmaceutical company experienced a massive de-rating in 2010,” said Colwell.
“Sentiment was poor because of high exposure to patent expiries, and there was scepticism over late stage pipeline and the lack of growth.”
“The stock was trading on the biggest discount ever to its peer group, with the market undervaluing the resilience of its cash flow generation, and ignoring any M&A solution. This is why we bought into it.”
Colwell says that new chief executive Pascal Soriot’s re-focusing of the business – including the revitalisation of its research and development [R&D] capabilities – has contributed to its improved share price performance of late, but he thinks there is more to go in the recovery.
Performance of stock and index over 5yrs
Source: FE Analytics
Shares have rallied into 2014, but Colwell says the 5 per cent yield is still very attractive – particularly as the dividend is twice covered by cash flow. He adds that the potential for acquisitions of late stage or on market products also bodes well for future capital growth, as does its exposure to emerging markets.
Colwell has 4 per cent of his Threadneedle UK Growth & Income fund in Astra, which is currently trading on a forward P/E ratio of 15.8 times.
Imperial Tobacco
“The valuation has been overly impacted by negative sentiment from the eurozone weakness, as well as worries over plain packaging, illicit trade, and e-cigarettes,” the manager explained.
“It has a high single digit free cash flow yield and its dividend yield was at a 10 year high relative to the market last year [5 per cent].”
FE data shows Imperial Tobacco has underperformed the wider FTSE 100 – as well as the FTSE All Share Tobacco index – over a five year period, with performance particularly poor since mid 2012. Performance over the past couple of months has been much better, though.
Performance of stock and indices over 5yrs
Source: FE Analytics
Colwell says the stocks are protected against further downside because of a number of potential take-over approaches, as well as the fact management has the option to dispose of non-core assets.
The UK Growth & Income portfolio has a 3 per cent weighting in Imperial, making it a top-10 holding. The stock is on a forward P/E of 11.8 times.
Colwell runs five funds at Threadneedle, all investing for both growth and income. All are five crown-rated, including the £2.7bn UK Equity Income and UK Equity Alpha Income fund, which he runs with FE Alpha Manager Leigh Harrison. Both sit in the IMA UK Equity Income sector.
Two of his funds – Threadneedle Managed Income and Monthly Extra Income – sit in the IMA UK Equity & Bond sector – while the Threadneedle UK Growth & Income is in IMA UK All Companies.
Speaking about the equity portions of his portfolios, he said: “Our main investment rule is to look for businesses where the ability to grow the dividend in a sustainable manner is not already reflected in the valuation.”
“We also believe that it’s important to be contrarian – sometimes the best long-term income opportunities can be found in stocks that the market has chosen to shun.”
“The best example of stock that has worked for us in that regard over last few years is BT. It was always in the headlines for the wrong reasons back then but now it has recovered and grown its dividend, proving that it could not only fund the pension deficit but grow the business as well.”
Performance of manager versus peer group composite over 3yrs
Source: FE Analytics
The strong performance of all of Colwell’s funds has seen the manager beat his peer group composite over a one, three, five and 10 year period.
His five funds are yielding between 3 and 3.7 per cent. All are top quartile performers in their respective sectors over a three year period.
This article was written in collaboration with and is sponsored by Threadneedle Investments.