The UK banking sector was plagued with bad news following the period immediately after the financial crash, but has rebounded strongly over recent years as balance sheets have been on the mend and the UK economy has strengthened.
Performance of indices over 5yrs
Source: FE Analytics
Because of that, it isn’t that uncommon to see Lloyds, Barclays and even RBS featuring in various IMA UK All Companies funds’ list of top-10 holdings: Fidelity Special Situations, R&M UK Equity Long Term Recovery and Schroder Recovery all have a decent weighting to the sector.
However Message, whose four crown-rated fund sits in the IMA UK Equity Income sector, has been buying UK retail banks for his portfolio despite the fact that the large majority of them either have a very small payout or aren’t paying a dividend at all.
“We have been gradually rotating into financials recently and the sector now makes up 35 per cent of the fund, which is quite a big weighting. Ten per cent of that is in banks, such as Lloyds, Barclays and HSBC,” Message (pictured) said.
“While I don’t think it will be plain sailing for these companies, I think the trajectory is positive.”HSBC is already a popular stock among equity income managers as not only is it paying a healthy dividend, but it is seen as the safest UK bank because it emerged from the financial crisis relatively unscathed.
FE data shows that 54 funds, totalling 60 per cent of the IMA UK Equity Income sector, count HSBC as a top-10 holding. They include popular portfolios such as Artemis Income, Rathbone Income and Trojan Income.
However, Lloyds has been a different story altogether as it isn’t even paying a dividend at the moment. It was bailed out by the government after the crash and has been hit with various issues such as the PPI scandal.
Following a period of deleveraging, however, the share price has rocketed and the Government has already started to offload its stake.
Performance of stock vs index over 3yrs
Source: FE Analytics
Plans are in place for Lloyds to start paying a “modest” dividend early next year. Message says that as dividend growth is such an important part of any investor's portfolio, buying now will mean the income he receives will be much greater than it would be if he were to wait until the bank starts distributing.
“I’m happy to buy it now and wait,” Message said. “They have already announced that they are aiming for a pay-out ratio of 50 to 60 per cent, which should mean you are getting a meaningful dividend yield. I think it makes sense to wait for that to come through.”
“We have done it in the past with the likes of ITV and Wolseley as we bought them when they weren’t paying a dividend and the income we have received was material because we bought at a lower share price.”
“While I don’t think they will be the giants they were in the past, there is scope for banks to become a much larger part of the income market again.”
No funds in the IMA UK Equity Income sector count Lloyds as a top-10 holding. Barclays, on the other hand, sits somewhere between HSBC and Lloyds, because although it is paying a dividend, the yield is only around 2 per cent.
Nevertheless, like Lloyds, Message expects a greater pay-out from Barclays in the future.
“It isn’t contributing much to the fund’s overall income payout today, but I’m expecting it to be much more meaningful over the next few years,” he said.
Although Message is clearly bullish on the banks, FE Alpha Manager Neil Woodford, who is commonly viewed as the best equity income manager in the business, has sold his exposure to the sector.
The star manager bought HSBC last year which was the first bank he owned in more than 10 years.
He described it as the best option in a troubled sector and a “conservatively managed, well-capitalised business with a good spread of international assets”.
However, he has already exited that position in his Woodford Equity Income fund due to concerns that the management, and other companies in the sector, will be faced with even more fines.
Message says there is another reason aside from increased dividends why now is a good time to buy into the sector.
“Financials and banks are obviously areas that you would expect to benefit from higher interest rates. HSBC, for instance, has a massive surplus of deposits on its balance sheet which is earning them nothing at the moment.”
“While bond yields have been falling this year, I think there will be a gradual rise in yields, which should also be good for these companies.”
FE Alpha Manager Mark Martin recently told FE Trustnet that he was upping his exposure to financials in his five crown-rated Neptune UK Mid Cap fund in preparation of the Bank of England’s first rate hike, which is expected to happen early next year.
Message has managed the £136m Old Mutual UK Equity Income fund since December 2009. It is a top-quartile performer in the IMA UK Equity Income sector over this time with returns of 80.2 per cent, beating its FTSE All Share benchmark by more than 20 percentage points.
Performance of fund vs sector and index since Dec 2009
Source: FE Analytics
Although Message hasn’t experienced a full market cycle, he has beaten the index and been a top quartile performer in three out of the four calendar years he has run the fund. The exception was in the falling market of 2011.
Although he is willing to wait for a higher level of income from his banks, Message’s Old Mutual fund currently yields 4 per cent.
That is largely a function of the manager’s decision to sell down his positions in domestically facing stocks that have performed well for him, but now have relatively low yields, and to add to mega caps such as Rio Tinto, BHP Billiton and the oil majors which have lagged the recent rally, but now offer a healthy yield.
Old Mutual UK Equity Income has an ongoing charges figure (OCF) of 0.96 per cent.
