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Matt Hudson: Why now is the time to buy UK banks for income

26 June 2015

Schroders’ Matt Hudson explains why he believes banks are one of the most interesting areas of the UK market to seek income from.

By Lauren Mason,

Reporter, FE Trustnet

There are plenty of opportunities in the UK’s banks now that risk metrics have improved and dividends are picking up, according Schroders’ Matt Hudson (pictured).

The manager, who celebrated 10 years at the helm of the Schroder UK Alpha Income fund earlier this week, has been overweight financials for the past couple of years.

However, his focus in this area has recently shifted from specialist financials and life insurance to the banking sector, due to the prospect of banks paying dividends once more.

“We were wary about UK dividends at the start of the year but the outlook has improved over the past six months and we feel more positive about the market,” he said.

“The prospect of the banks returning to the dividend list is a major factor here and this will be great from an income perspective as it will give investors looking for income a greater choice when searching for either high yields or dividend-growth opportunities.”

Three of the biggest overweights in Schroder UK Alpha Income compared to the FTSE All Share benchmark are specialist asset manager ICG Intermediate Capital, financial services group Provident financial and Barclays.

The former two stocks, which Hudson describes as “specialist lenders”, have been allocated overweight positions for their above-benchmark yields and growing dividends.

Major banks, he admits, have not always been flavour of the month for the five FE Crown-rated fund.

“Financials has been a big overweight in my fund for a while, but what has been in there historically was specialist financials like ICG and Provident Financial,” the manager said. “And if you look back a year or so ago you would see two or three life insurance companies in the top 10 [biggest overweights].”

Now, however, he believes that banks are one of the most interesting areas to be investing in seven years on from the financial crisis, particularly from a dividend perspective.

Since 2009, the FTSE 350 Banks index has returned 36.78 per cent, which is a third of what the FTSE All Share has returned over the same time period, according to data from FE Analytics.

Performance of indices since 2009

 

Source: FE Analytics

 

But since the start of the year the FTSE 350 Banks index has managed to outperform the FTSE All Share.

“Banks have spent the last five or six years rebuilding their capital, improving their control systems, trying to do all the things that perhaps in hindsight they should have done before. But I think that where that’s going to lead to is a set of assets that have got much better capital positioning and a better understanding of where the risks lie,” Hudson said.


 While the increase in capital has improved the risk metrics of banks, the manager concedes that this hasn’t overly helped from a dividend perspective as it can be a struggle for banks to pay out money regularly when trying to build capital.

However, Barclays and Lloyds, the two largest bank holdings in Hudson’s portfolio, have managed to beat the FTSE 350 Banks sector so far this year by 6.99 and 8.28 percentage points respectively and are both currently paying dividends.

Performance of stocks vs index in 2015

 

Source: FE Analytics

Another fund manager who is finding opportunities in banks at the moment is Stephen Message, who manages the five FE Crown-rated Old Mutual UK Equity Income fund.

Earlier this year, he told FE Trustnet that he had increased the financials weighting of his fund to 37 per cent, and warned that his peers may be missing out on attractive dividend opportunities from the sector in the future.

His conviction has since increased further, as the fund currently holds a 41.1 per cent weighting in the sector.

He was particularly optimistic about his holdings in Barclays, Lloyds and HSBC, describing the stocks as a “nice mix” of banks.

“I think you need to look a few years out because the dividend potential of those companies is significant. I think Lloyds will return to the dividend register this year and I think the dividend pay out ratio at Barclays can rise a fair bit,” he said in January, before Lloyds resumed dividends.

“If I’m sitting here next year or the one after, those dividends will be materially higher. They will suddenly appear on the income investor’s radar again but I don’t want to wait because I think the potential for capital growth between then is quite strong.”

While Hudson has all three of these stocks in common with Message, he points out that he has a significantly smaller weighting in HSBC than he does in Lloyds or Barclays.

Last year, star manager Neil Woodford sold out of HSBC as he deemed the stock to be too risky and worried that banks faced excessive fines from regulators.

“I think we’re coming towards the end of that process, being that there are a couple of big outstanding litigation issues to be settled, not just for HSBC but for other ones as well,” Hudson reasoned.

“HSBC is an interesting asset because, in some ways, it should be one of the most reliable payers but we’re uncertain about where they’re going to end up in the future, which businesses are going to be listed and how the ring fencing is going to work.”

“I think with Lloyds and Barclays we’ve got a better understanding of them, we’re closer to the momentum of those agreements coming through.”


 While it hasn’t always been sitting in the top 10, Barclays has been in Schroder UK Alpha Income since the recovery phase began in 2009.

Hudson has since increased the fund’s exposure to the bank to 3.93 per cent, placing it in the fund’s top five holdings.

He says this is because he has grown more comfortable with the actions of the bank and is optimistic about the appointment of new chairman John McFarlane, who took the helm in April this year.

“I think this year will be a really important year to watch how the stock goes forward, and we’ve already seen multiple attempts to bring some riskier parts of the business under control,” the manager explained.

While Hudson admits that banks still have some way to go before becoming a low-risk and reliable asset, the progress made has given him an optimistic outlook for dividend-paying UK companies in the future.

“While there remain some stock-specific risks for dividends among some big dividend declarers, we feel some of the downside macroeconomic risks to UK dividends have started to diminish and we maintain our balance of premium yields and dividend-growth opportunities,” he added.

Over five years, Schroder UK Alpha Income has achieved a top-decile total return of 107.21 per cent, outperforming its sector average and benchmark by 26.34 and 38.36 percentage points respectively

Performance of fund vs sector and benchmark over 5yrs

Source: FE Analytics

The fund has a clean ongoing charges figure (OCF) of 0.91 per cent and yields 3.93 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.