The re-rating in UK Equity Income stocks is justified by the great shape of UK companies and increasing confidence in the sector, according to Threadneedle’s Leigh Harrison (pictured), who thinks fears of a bubble are overstated.
Negative real interest rates have pushed more and more investors into dividend paying stocks in recent years, helping UK Equity Income funds to outperform their UK All Companies counterparts over a one and three year period. The likes of Ruffer’s Steve Russell believes a bubble is forming in the sector, and expects highly rated stocks to come under earnings pressure; however, FE Alpha Manager Harrison thinks it is too early to focus on these fears.
“Payout ratios are only slightly above long term averages for the UK market, and are in part reflective of increasing corporate confidence,” said Harrison, who runs the £2.7bn Threadneedle UK Equity Income fund.
“Balance sheets are strong, and in much better shape than in 2008, meaning dividend yield is a good indicator of value.”
Performance of IMA sectors over 3yrs
Source: FE Analytics
“There has been some yield compression as shares have performed well, but UK equities are still attractively valued versus bonds and other equity markets.”
Leigh Harrison adds that the UK economy is in increasingly good shape, and the global economic recovery should help companies grow their earnings in the future.
“There were good growth figures for 2013 and the outlook for 2014 is also strong, supported by Bank of England, OBR and IMF forecasts,” he said.
“Unemployment has come back to the Bank of England’s 7 per cent target level far sooner than expected, and after five years of above target inflation, inflation is now marginally below the 2 per cent target.”
“That said, 2013 GDP growth was largely consumption driven, in some part as a result of a falling savings ratio and one-off factors like PPI claims. As a result, we are now looking for a sustainable upturn in investment to give the recovery firmer footing.”
Harrison admits more cyclical areas of the market, particularly retail, have had a significant re-rating without a great deal of earnings growth.
“If the earnings growth doesn’t come through, they would be susceptible to a sell-off,” he explained.
However, he says he is avoiding this area of the market, targeting cheaper mega cap stocks in the energy, pharmaceutical and consumer staples sector.
Harrison’s co-manager on the Threadneedle fund Richard Colwell, said in a recent interview with FE Trustnet: “Post the financial crisis there were other 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.”
Fears over a bubble have centred on “bond proxy” stocks – those that investors have been buying as an alternative to the low-yielding fixed interest market, as they have many of the same characteristics.
Harrison thinks the comparison is overly simplistic, and doesn’t think stocks in sectors such as pharmaceuticals and tobacco will automatically sell-off as bond yield rise.
“Some defensive stocks with steady cash flows are often seen as bond proxies,” said Harrison. “Their poor performance following the first talk of QE tapering in May last year to some extent reflects that.”
“However, as shown by the recent performance of AstraZeneca and Imperial Tobacco, for example, there is more to these stocks than just that.”
“The yields on offer are often more attractive than bonds, they are backed by strong cash flows, and crucially the dividends in many cases are growing – again, unlike bonds.”
FE data shows Astra and Imperial are up 14.52 and 8.17 per cent year-to-date respectively. Over the same period, the iBoxx Sterling Overall All Maturities index has returned 2.69 per cent.
Performance of stocks and index in 2014
Source: FE Analytics
The companies are both top-10 holdings for Threadneedle UK Equity Income, with a combined weighting of over 10 per cent. This has helped the fund outperform both its sector and All Share benchmark so far in 2014, with returns of 2.05 per cent.
Though Harrison insists fears of a bubble are overdone, he accepts the market has had a very good run and doesn’t expect returns in 2014 to be as strong as 2012 or 2013.
Though the UK is in good shape, Harrison says he is watchful of international developments. He points to QE tapering in the US, geopolitical risks in areas such as the Ukraine and emerging market growth concerns as among the biggest threats to UK markets.
A number of UK Equity Income managers have increased their exposure to battered mining companies such as Rio Tinto and BHP Billiton in recent months, but Harrison says the sector remains too risky for his taste.
“Management changes and increased rhetoric around capital discipline has encouraged investors, but we remain zero weight miners in the UK Equity Income fund,” he said.
“The outlook for commodity prices and demand from China is uncertain, and I think there is some way to go to rein in capex to pre-crisis levels and improve cash flows materially.”
Threadneedle UK Equity Income has been one of the most consistent funds of its kind over the past decade, since Harrison took it over in February 2006.
It is a top-quartile performer in the IMA UK Equity Income sector over a one, three and five year period, and has been consistently less volatile, coping better in falling markets.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
In 2011, for example, when the All Share fell 3.46 per cent thanks to fears surrounding a break-up in the eurozone, Harrison managed to deliver a positive return of 0.4 per cent.
Strong performance has led to significant inflows of late, with £355m going into the fund in the last 12 months alone.
Harrison says he and his team are keeping a close eye on capacity, but have no concerns at present.
“We are very conscious of capacity and take it very seriously,” he said. “It is under constant review and we engage regularly with our risk team to analyse portfolio liquidity.”
“Capacity issues are mitigated by our mid to large cap focus, low turnover, portfolio diversification and our contrarian value approach.”
“We do not have a specific capacity limit but believe there is currently plenty of headroom,” he added.
This article was produced in collaboration with and is sponsored by Threadneedle.