Kirrage: Why I’m avoiding the consensus UK Equity Income value-play
20 May 2014
Even core UK Equity Income managers like Artemis’ Adrian Frost have been buying into the battered mining sector of late, but the value expert thinks stocks such as Rio Tinto are a long way from being cheap.
An improving economic outlook and the search for yield have pushed valuations among UK dividend-paying companies to elevated levels in recent months. Those looking for value opportunities have had to take on more risk as a result, and the mining sector – which has had a terrible time over the past three years or so – has been bought in huge volumes by UK Equity Income managers.
FE data shows that 31 – approximately a third – UK Equity Income funds hold Rio Tinto in their top-10, while 15 hold BHP Billiton. Nine funds, including the £971m Aviva UK Equity Income portfolio, hold both.
Kirrage (pictured) and co-manager Kevin Murphy are among the most respected deep value managers in the UK, but while you might guess they were at the front of the queue buying up battered mining stocks, they continue to sit on the sidelines, largely disinterested.
“You’ve got a lot of people talking about income and mining at the moment, but we’re yet to pull the trigger,” he said.
“The reality is that we are [value-obsessed], and at the right price we are prepared to buy anything. When we invest we want something that is cheap, has a nice yield and is going to grow its dividend.”
“There are better arguments for investing in mining. They’re generating a lot more cash and there’s better management, but I am not sure they are all that cheap.”
“In some respects it reminds me of the banks in 2007; a lot of them had big yields and low P/E [price-to-earnings] ratios and a lot of people said they were therefore cheap, but we all know what happened there.”
Kirrage says that though there has been a correction in miners over the past three years, but points out that many of the stocks have come from very high levels.
“For 10 years they were pretty much phenomenal. If you look at the price of iron ore and copper, they are still at very high levels,” he said.
“Everyone is talking about value, but the share prices of BHP and Rio don’t assume they are going to collapse. To invest in them I think you need confidence that prices are going to stay the same.”
Performance of stocks and indices over 10yrs
Source: FE Analytics
“If you take the average price over the past 20 years, which includes 10 very good years and 10 not so good years, they are not nearly as cheap as many are saying. We’re not jumping on the bandwagon.”
While Rio Tinto has had a good run over the past 12 months, the mining sector as a whole has not rallied in the way many managers had hoped. FE data shows that FTSE 350 Mining Index has marginally underperformed the wider All Share over one year, with returns of 5.87 per cent.
Performance of stocks and indices over 1yr
Source: FE Analytics
Kirrage says that the reliability of income from mining is a particular cause for concern.
“It’s a hugely cyclical industry – it certainly isn’t a safe haven and not a good place for dividend growth,” he said.
“Dividend growth comes from good balance sheets, and they can go from being very good to very bad very quickly in mining.”
He says that the move into mining is forced in some cases, and a product of fund managers getting frustrated with their expensive holdings.
“It’s a hard market to invest in because everyone wants to rotate into the next cheap thing,” he explained. “Sometimes if it looks like a duck and sounds like a duck – it isn’t a duck. It’s just someone doing a good duck impressions.”
“I might be wrong of course, but I can’t lose money from not investing.”
Among the highest profile holders of Rio Tinto include FE Alpha Manager Carl Stick, who has a 4.4 per cent stake in his Rathbone Income fund. Adrian Frost’s Artemis Income has a large position in the company as well, though it isn’t quite a top-10 holding.
BHP Billion is particularly popular with Aberdeen UK Equity Income, which has a 4 per cent position in the stock.
While some value managers such as Investec’s Alastair Mundy are sitting on high levels of cash because of what they deem to be a lack of opportunities, Kirrage says he and Murphy are still finding cheap stocks.
“Which is cheaper – Rio or Morrisons? There is an argument of a structural decline in supermarkets, shown by the recent price war, but I would say this is a more mature, stable and certainly a more cheaply priced stock,” he said.
“Food retailers are becoming the nobody sector. Everyone is pointing to the negatives, but the same as true of tobacco in the early 2000s and banks post-2008.”
The £1.4bn Schroder Income currently has a 3.6 per cent weighting in Morrisons, and also counts Tesco as a top-10 holding.
Kirrage and Murphy also like banks at the moment, believing that the likes of Lloyds and Barclays will soon be paying a sustainable dividend to investors. He’s also recently bought a position in HSBC.
Unlike some of their rivals, the duo aren’t currently building their indirect emerging market exposure, believing that stocks such as Sab Miller and Unilever are not yet cheap.
“We’d be buying emerging markets not when people are [disinterested] like now, but following something like an Asian crisis. We’ve come close to some stocks but never bought. Anglo American is interesting but we haven’t got the confidence yet,” he added.
Schroder Income is a top quartile performer in its IMA UK Equity Income sector over one, three, five and 10 years. It has returned 47.18 per cent over a three year period, putting it well ahead of both its peers and its benchmark.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
An increasing number of funds are under pressure to leave the UK Equity Income sector, due to their inability to consistently hit their 110 per cent yield target. High profile exits include Henderson UK Equity Income & Growth and Invesco Perpetual High Income.
Kirrage says he and Murphy are “keeping one eye” on the situation, adding that the strict guidelines run the risk of adversely impacting investors.
“It’s turning into a farcical situation. Those dropping out are effectively saying that they are doing what’s in the interest of their clients, as they are not comfortable with high yield. I have sympathy with that,” he said.
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