The re-rating in UK equities in 2012 and 2013 has led many experts to question how much value is left across the market, with some looking to protect themselves against a possible correction. Funds in the IMA UK Equity Income sector have had a stuttering start to 2014, with the average portfolio slightly down year-to-date. However Frikkee (pictured), who heads up the Smith & Williamson UK Equity Income fund, remains optimistic about her chances of delivering strong returns this year.
“I think we will see a positive return this year. I don’t think it will be like last year when we saw 20 per cent plus, but I think you will see returns between the 8 to 12 per cent band, and hopefully our fund can do more than that,” she said.
“As long as earnings growth comes through, I think the current valuation is fair when looking at the dividend yield and price-to-earnings [P/E] ratio. On a stock specific level, I think multiples can grow to very much support valuations. The question is, where is the earnings momentum coming from?”
Frikkee has a bias towards the cyclical global recovery in her portfolio, which is reflected by her big bets on areas such as financials, industrials and mining. The manager argues that there is ongoing support for the recovery in the UK, reflected by Chancellor George Osborne’s Budget in March this year.
“Minimum wage is up, there’s a lower level for the initial tax threshold, and help to buy has been extended. Overall, there is ongoing support for people’s disposable incomes,” she said.
“This can be a double-edged sword of course. It’s always better for people to have more cash to spend as consumption is such a big part of GDP, but you don’t want this to hit employees too much.”
Frikkee highlights GKN as an example of a stock that is capable of delivering strong returns this year, but points to mining as being at the sweet spot from a sector point of view.
“Our top five positions are very different to other funds,” she explained. “Stocks in our portfolio have to have positive valuations, quality and the ability to have earnings surprises on the upside.”
“GKN has a 2.5 per cent weighting in the fund. Underlying earnings and cash flow growth is where I want it to be. It has been hit by currencies, but that can always go the other way.”
“We’re also looking at the quality miners – Rio Tinto and BHP, which were already in the fund, but which we’ve increased recently. Anglo American doesn’t have the return on equity, which simply means that it can’t grow.”
“Valuations on miners are modelled over a 15 year period. They are looking to capture a lot of cycles, and it’s a fact you will have good and bad times over this time.”
“Miners have a nasty habit of buying up assets at the very top of the cycle, and selling down at the wrong price. Both Rio and BHP have been on multiples as low as this for the last 15 years, which includes the Asian crisis and 2008.”
Performance of stocks over 15yrs
Source: FE Analytics
“Expectations are very low. They’ve had a very bad time – margins have been squeezed and they’ve had a large cost base. However, they are in a position again when they can grow their earnings, and I feel the potential for upside in earnings given the recent forecasts is attractive.”
“Since the third quarter of last year they’ve had good numbers, and in the fourth quarter of last year numbers were good for all miners. They’re starting to deliver good volumes, earnings and cash flow growth, which is exactly what I’m looking for.”
“The momentum is there. It’s very much chicken and the egg, in that many investors will only buy once things improve. Even if investors go neutral a lot more money will be going into these stocks,” she added.
Frikkee adds that worries over slowing demand for commodities in China shouldn’t impact the two companies as much as many investors fear.
“What people haven’t cottoned onto is that though China is importing less iron ore overall, there is an interesting trend with pollution, with the government demanding higher quality produce,” she said.
“This is only a positive thing for BHP and Rio, as China is having to pay up for this extra quality.”
Rio Tinto and BHP are both top-10 positions in Smith & Williamson UK Equity Income, with a weighting of 2.5 per cent apiece.
Both have seen their share prices recover in recent months – particularly BHP, which has posted positive returns of over 4 per cent in 2014. However, Frikkee says both have further potential upside of 25 to 30 per cent.
Frikkee has herself managed a positive return this year, building on her strong performance in 2013.
FE data shows that Smith & Williamson UK Equity Income has returned 15.18 per cent since she took over the fund in July of last year, compared to 11.83 per cent from the IMA UK Equity Income sector average and 8.21 per cent from the FTSE All Share.
Performance of fund, sector and index in 2014
Source: FE Analytics
This figure puts the fund in the top quartile of its sector over the period. At 4.05 per cent, the fund is also yielding more than its peer group.
Frikkee’s emphasis on companies at the lower end of the FTSE 100 and the FTSE 250 has helped drive performance in recent months, which she explained in more detail in an FE Trustnet article earlier this year.
She points to financial services outfit St James’s Place, which is at the bottom end of the FTSE 100, as one of her highest conviction ideas at the moment.
“It had a 2.2 per cent position which we’ve moved to 2.5 per cent recently,” she said.
SJP recruits partners and has a profit share agreement with them. Long-term partner growth has been 5 per cent, but Frikkee says RDR helped this grow to 9.5 per cent in 2013.
“The companies’ book value grew by 25 per cent as a result. We think partner growth could be as high as 19.5 per cent in 2014,” she added.
Frikkee says there is 30 per cent upside in SJP, even though its share price has more than doubled over the past three years.
While the manager is optimistic on the whole, she says the re-rating of recent years has led some companies to hit unjustifiable multiples. She says investors must be more discerning with their stock picking as a result.
“Rolls Royce and BG were darlings of the market, but have been punished fiercely this year for not hitting their numbers,” she said.
Performance of stocks over 1yr
Source: FE Analytics
“I don’t think whole sectors are at risk, though some of the consumer staples are finding it very tough at the moment. Food producers and beverages are a good example. Most of the growth has come from emerging markets, and they’ve been hit by currencies.”
“Unilever has also struggled. It’s not growing in the US and Europe. It’s doing best in its healthcare products, but because it’s such a diversified company it’s valuation relative to its growth just doesn’t looks appealing to me.”
Smith & Williamson UK Equity Income has clean share class ongoing charges of 0.82 per cent.
