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Three contrarian sectors for income investors

21 April 2015

The Saracen UK Income fund, released last month by Scott McKenzie, holds chunky weightings in mining, financials and emerging market bonds despite the headwinds facing those sectors.

By Lauren Mason,

Reporter, FE Trustnet

Commodities, financials and emerging market debt are the most promising contrarian plays in the current market , according to Saracen UK Income fund manager Scott McKenzie (pictured), who says that not only do they offer decent long-term growth but are attractive options for income-seeking investors.

McKenzie, who joined Saracen in August 2014, launched the multi-cap fund less than a month ago and uses a value-based investment philosophy to pick stocks.

As a result, many of the stocks chosen are unloved and unfashionable. Nevertheless, are number of high profile managers – such as Alastair Mundy, George Godber and the Schroders duo of Nick Kirrage and Kevin Murphy – have forged successful careers by adopting a contrarian approach to the market.

With that in mind, McKenzie highlights the three sectors which are currently hated by the market but offer investors, who can stomach the volatility, decent long-term capital and income growth.

 

Miners

A prime example is the mining sector, according to McKenzie, who holds 4.4 per cent and 2.8 per cent in commodity giants Rio Tinto and BHP Billiton.

 “Lots of people are very negative on the mining sector and, in the short-term, I can understand why that’s the case because things look pretty grim today,” he admitted.

“But, one of the benefits we have is that we can take a five-year view. All of the research we do looks over the next five years and looks back to the previous five years, so effectively, we’ve looked at 10 years of data, and we’re trying to forecast the next five years.”

“The prices of commodities and metals are falling and that’s been pretty bad for those companies. However, from the research we’ve done on both Rio Tinto and BHP, we think they’ll maintain their dividends which we think is the most important thing.”

“We’re more than happy to buy companies that people don’t like in this fund,” he added.

Both BHP Billiton and Rio Tinto have predictably had a rough ride recently following the plummet in cost of metals such as iron ore and copper which has largely been due to China’s economic slowdown and subsequent drop in consumer demand.

In fact, over the last 12 months, BHP Billiton is down 18.73 per cent and Rio Tinto is down 8.83 per cent.

Performance of stocks over 1yr

 

Source: FE Analytics

In light of macroeconomic affairs providing huge headwinds for the sector, it may be difficult to see how these stocks will improve over the next five years.

However, McKenzie’s bottom-up stock selection approach means that he has chosen those stocks without basing his decision on the sector’s performance as a whole.

“A lot of it’s to do with the smaller competitors going out of business,” he explained.

“One of the features of the weakness in the metal price is that a lot of small companies will have to close because the line will go bust or the mines will just stop producing.”

“I think, in the case of Rio Tinto and BHP, because they’re such large companies, they have very low costs compared to many other people in the mining industry, so they can take the pain for a much longer time period than the small companies can. “

Despite acknowledging that the price of iron ore has decreased by 60 per cent in the last year, he believes that it won’t take much for the price to recover. 


 

Emerging market debt

The highest-yielding stock in McKenzie’s portfolio is also unloved – Ashmore, a fund management company based in London, invests primarily in emerging market bonds.

“Emerging market bonds are very out-of-favour at the moment, so Ashmore has struggled over the last couple of years,” he said.

Since 2013, the stock has made a loss of 14.67 per cent. However, it currently yields approximately 6 per cent.

McKenzie said: “It’s been a fairly poor performer. It’s very interesting, though, because it has some of the characteristics that Saracen has. Roughly 60 per cent of the shares are owned by management and staff, the rest is in public hands.”

“It’s got a huge employee ownership, it pays a very high dividend, which again, we think is absolutely rock solid. We don’t see any scenario where they would cut their dividend, and for the management and the staff, the dividend is very important to their overall culture as well.”

“The company has hundreds of millions of dollars in the bank so, even if things are pretty grim, it’s going to survive. It’s not undergoing financial difficulty - quite the opposite.”

In terms of debt investment, emerging market bonds have certainly underperformed in comparison with their developed market peers according to data from FE Analytics.

A significant catalyst for this was the “taper tantrum” in May 2013, when the US Federal Reserve warned markets that it was planning to reduce its quantitative easing programme.

Since then, investors have grown concerned about tighter monetary policy in the US and the effect this will have on the asset class, leading to poor performance from the IA Global Emerging Markets Bond sector.

Since the taper tantrum, emerging markets bond funds have lost 7.87 per cent, while the IA UK Gilts sector has delivered double digit gains.

Performance of indices since taper tantrum

Source: FE Analytics

McKenzie believes that, despite the emerging market bond sector’s poor performance, developed market bonds are overheated and investors will move into emerging market bonds again over the next couple of years.

“It’s similar to the mining sector – it‘s very out of favour today, but if things change, the stock price could drive substantially,” he continued.

The yields on emerging market debt funds certainly look attractive compared to other areas of the fixed income market.

For instance, 10-year UK government bonds are currently yielding 1.58 per cent, 10-year US government bonds are yielding 1.89 per cent and 10-year Japan bonds are yielding 0.31 per cent. On the other hand, many funds within the emerging market debt sector are paying more than 5.5 per cent.


 

Financials

The Saracen UK Income fund is also very overweight in financials, another unpopular sector. However, McKenzie has chosen his financial stocks, such as Barclays, Standard Life and Aviva, based on strong balance sheets and high dividends, allocating 31.5 per cent of the fund to the sector.

McKenzie also holds 4 per cent of the fund in Lloyds Banking, which two months ago, paid its first dividends in more than six years.

Things have been looking up for the banking sector in general, following a strengthening economy and growing appetite for risk among investors. However, many investors have concerns about the sector due to election as banks, in particular, are proving to be a major battleground between the major political parties.

Investors are also nervous about insurance companies as though they have been very popular with UK managers in the past, recent changes to the pension system have been seen as headwind.

However, McKenzie is content that, from a bottom-up perspective, the stocks he has chosen for his new fund will do well.

 “The main characteristic with a lot of these companies is that most of them have had issues in the past and we think they are recovering,” McKenzie said.

“Quite a lot of these companies are unloved, they really have had issues. And if we do our research correctly, we can identify that they’re about to improve, so that’s one thing we’re trying to do in our research.”

According to Saracen Fund Managers, the forecast portfolio yield of the Saracen UK Income fund is 4.3 per cent with bi-annual payments. 

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