Richard Colwell remains cautious on the outlook for UK banks, as he believes there are much more attractive parts of the market that are being overlooked by other investors.
Banks were out-of-favour among income investors in the years following the financial crisis after their earnings plummeted and dividends were cut. In the case of two of the UK’s biggest groups – Lloyds and Royal Bank of Scotland – dividend payments were put on hold after they were bailed out by the government.
The graph below shows how UK banks, as represented by the FTSE All Shares Banks index, lagged the wider market in the five years to 31 March 2015. The index made a return of little over 0.30 per cent with dividends included over the period, while the total return from the FTSE All Share was just under 50 per cent.
Performance of indices between 31 Mar 2010 and 31 Mar 2015
Source: FE Analytics
However, sentiment towards the sector has started to improve as banks worked to clean up their balance sheets and the economic outlook strengthened. News that Lloyds Banking Group has become a dividend payer again for the first time since its bailout in 2008 made more income investors look to this part of the market.
One manager who is not fully convinced by the banking sector, however, is Colwell, who co-manages the five FE Crown-rated Threadneedle UK Equity Income and Threadneedle UK Equity Alpha Income funds with Leigh Harrison.
FE Analytics shows that the average fund in the IA UK Equity Income sector has 22.3 per cent of assets in the financials sector, which includes banks as well as businesses such as insurers and asset management houses.
Colwell has less in this area than his average peer: Threadneedle UK Equity Income fund has just 12.2 per cent in financials while Threadneedle UK Equity Alpha Income fund has 16.9 per cent. These are both underweight their FTSE All Share benchmark, where 25.8 per cent comes from the financials sector.
The manager’s Threadneedle UK Growth & Income fund, which sits in the IA UK All Companies sector, is also underweight financials, holding 13.1 per cent in the sector. (All sector data is to 31 March 2015)
“We continue to be cautious on banks, with others seeming to view the sector as becoming increasingly attractive for income investors. Lloyds coming back onto the dividend roster has been a signal for a lot of bullishness on dividend prospects in the sector,” Colwell (pictured) told FE Trustnet. 
“Despite this, we do not mechanically buy or sell in our income funds based solely on the dividend yield and with the fundamental challenges and industry headwinds, we see no reason to change our investment case at this point. We certainly do not believe the banks will be able to grow their dividend as quickly as the bulls are suggesting.”
The manager says the fortunes of Lloyds are heavily linked to the UK housing market, which has been buoyed in recent years by measures such as the Government’s Help to Buy scheme.
However, he points to the Bank of England’s stress tests, which showed that the bank’s capital reserves would be “extinguished” in the event of a 35 per cent correction in the housing market occurring alongside rising unemployment.
“Despite the well-received recent results, in my view, given the current valuation based on price/tangible book, we find it difficult to view Lloyds as an attractive opportunity,” he added.
However, the manager says he is finding opportunities in other parts of the market – even those that might prove off-putting to some income investors.
“Where we do find interesting opportunities, ironically, is in the likes of GlaxoSmithKline and Centrica, even despite the dividend cut in the case of the later, and threat of a cut in the case of the former. We feel that the valuations are significantly more attractive with a more clearly defined cash-flow recovery path,” he explained.
“Neither were major holdings for us a year ago and we have had much larger weightings in the likes of AstraZeneca and National Grid that we continue to support. Our view is that, incrementally, we would prefer to build positions in these ‘ugly-duckling’ stocks as contrarian-value plays that should provide capital growth opportunities as well as improving income in the coming years.”
Both companies are now top-10 holdings in both Threadneedle UK Equity Income and Threadneedle UK Equity Alpha Income funds, with GlaxoSmithKline accounting for 6.8 per cent of assets in the former fund and Centrica making up 3.2 per cent.
Colwell has a strong track record in finding opportunities in parts of the market disliked by other investors. Past examples have included the likes of AstraZeneca, ITV and BT that were bought when they were unloved, with depressed valuations. These stocks have since performed extremely well, driving the capital growth component of the funds’ returns.
“Where we have found interesting opportunities recently is in the large-cap space with the likes of GlaxoSmithKline, Morrisons and Centrica as contrarian-value plays,” he said. Colwell hopes these names will follow AstraZeneca, ITV and BT in becoming successful recovery stories.
Threadneedle UK Equity Income and Threadneedle UK Equity Alpha Income both hold the top rating of five FE Crowns, thanks to their strong performance in terms of stockpicking, consistency and risk control over the past three years.
In addition, the £3.4bn Threadneedle UK Equity Income fund is a current member of the FE Research Select 100 list of preferred funds.
Between Colwell joining the fund in September 2010 and the end of 2015’s first quarter, the portfolio made a total return of 88.77 per cent and outpaced the FSTE All Share’s 54.59 per cent gain. The average IA UK Equity Income fund has made 69.48 per cent over this time.
Performance of fund vs sector and index over manager tenure
Source: FE Analytics
The FE Research team said: “Colwell and Harrison take a very contrarian approach, looking for the stocks which are out of favour with other investors for bad reasons. The result is a fund that is very different from its peers, which is a useful feature in a sector with many similar funds.”
“They avoid buying companies to take advantage of short-term rallies, but look for those with the potential to grow their dividend over the medium term which the market has yet to appreciate. They have carried out this strategy with skill, producing excellent overall returns.”
Threadneedle UK Equity Income Fund has a clean ongoing charges figure (OCF) of 0.86 per cent and currently yields 4.10 per cent, while Threadneedle UK Equity Alpha Income Fund has a 0.88 per cent OCF and a 3.80 per cent yield.
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