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The fund proving UK equity income investors don’t need to own the same old stocks

03 August 2015

Concentration risk in the UK equity income space is well known, but investors don’t have to give up income or growth by looking beyond blue-chip defensives – especially as a “perfect storm for income” could be on the horizon.

By Gary Jackson,

Editor, FE Trustnet

UK equity income investors have to prepare for “a perfect storm” that threatens to hit some of the most commonly held stocks in the sector, but Standard Life Investment’s Thomas Moore points out that looking beyond blue-chip defensive ‘bond proxies’ can be profitable strategy.

The IA UK Equity Income sector is one of the most popular among investors but suffers from many funds investing in the same few stocks. FE Analytics shows GlaxoSmithKline is found in the top 10 of 40.21 per cent of the peer group’s members (although this is down from 55.67 per cent one year ago).

BP is the second most frequent major holding, being found in 37.11 per cent of funds’ top 10s. AstraZeneca follows with 36.08 per cent, HSBC is in 32.99 per cent of top 10s and Imperial Tobacco and Royal Dutch Shell are both in 31.96 per cent.

Firms from sectors such as pharmaceuticals, oil, tobacco and utilities have long been favourites with equity income managers thanks to their regular dividend streams and perceived status as ‘safer’ stocks.

For defensive sectors such as pharmaceuticals and tobacco, central banks’ unconventional monetary policies since the financial crisis has boosted their popularity even further as investors moved from fixed income to the areas of the stock market that offered the most bond-like characteristics.

Performance of indices over 6yrs

 

Source: FE Analytics

However, Moore – manager of the £930.4m Standard Life Investments UK Equity Income Unconstrained fund and the £183.4m Standard Life Equity Income investment trust – believes that the income-paying stalwarts at risk from a number of factors, including the low oil price and the monetary policy moves of the Federal Reserve and the Bank of England.

“At the moment, it’s almost a perfect storm for income. If you’re a traditional income investor you have to worry about big oil; you have to worry about mega-caps’ earnings downgrades and the cash flow shortfall of companies like Glaxo; and on top of all of that, you have a rate rise leading to a de-rating.”

“In an environment of people just wanting bond-like characteristics, you can understand why ‘bond proxies’ have rallied from 11 times earnings to 14 or 15 times earnings. When rates go the other way, that’s when you have to be sure enough of the fundamentals that you’re not going to be blown out of the water by P/E contraction. I’m not convinced everyone is on top of this yet.”

Moore’s approach pays no attention to the make-up of the FTSE All Share and he only owns a stock if he has a positive view on it. This results in an unconstrained, concentrated and all-cap portfolio that looks very different from the index and from the typical UK equity income fund.

Standard Life Investments UK Equity Income Unconstrained, for example, has just 8 per cent of its assets in mega-caps with 22 per cent in large-caps. There’s 45 per cent in mid-caps and 24 per cent in small-caps. Its top holding is BT at 3.8 per cent, followed by Legal & General, Aviva, Vodafone and Reed Elsevier.

“We don’t feel obliged to own the same mega-cap income stocks as most income funds and we don’t feel we’re taking on more risk to achieve that,” the manager said.

“The reasons why conventional income managers will tell you they hold the likes of Glaxo and Shell will be for a high yield and to control risk by avoiding deviating from the index excessively. I think both of those arguments are bogus.”

While the concentration risk of the UK equity income sector is well known, there’s a perception that investors are giving up something if they look past the major dividend names and into other areas of the market.


 

However, as the below graph shows, the income earned on an investment of £10,000 since Moore took over the fund, investors in Standard Life Investments UK Equity Income Unconstrained haven’t had to give up on income.

For the purpose of comparison, we’ve included Artemis Income and Threadneedle UK Equity Income. Both are highly respected members of the sector with more than half of their portfolios in the mega and large-cap space – around 66 per cent in the case of the Artemis offering.

Income earned on £10,000 since 1 Jan 2009

 

Source: FE Analytics

Moore concedes that some of the most popular equity income names are “perfectly good” yield stocks, but he prefers to find companies that offer the potential for a growing dividend – albeit from a lower base – and decent capital appreciation on the way.

“Lots of the mega-caps are seeing no earnings growth and some are even seeing negative growth. With these you’re buying a stream of steady dividends and that’s about it – you’re getting a coupon almost, it’s like a corporate credit,” he said.

“Some of the best investments we’ve made over the past six-and-a-half years have been stocks with the potential to pay a dividend but not necessarily here and now.”

“You buy something like this and you believe in the management team to deliver for you, you hope to get earnings growth of about 15 per cent, the dividend will grow in line with earning assuming the pay-out ratio stays the same and, assuming the P/E is constant, the share price will grow with earnings.”

The manager also refutes the view that building a portfolio of large-cap defensives is a less risky approach than hunting across the whole market.

“What a of equity income managers are thinking about the likes of Glaxo or Shell is that their volatility tends to be much lower than the industrials, consumer stocks and banks. If you were a traditional equity income investor, you’d saying ‘I can’t consider these [more volatile stocks] because they’re high-risk; I have to play with things like healthcare and utilities’.”

Moore looks at risk across the whole portfolio, rather than on a stock-by-stock basis. This means will own low-risk stocks with decent income like National Grid, Direct Line and Hiscox but then hold high-risk names as well.

Despite this, FE Analytics shows that Standard Life Investments UK Equity Income Unconstrained has been the second most volatile member of its sector over the manager’s tenure, with annualised volatility standing at 15.78 per cent.

Maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – is also higher than the sector average at 17.32 per cent.

But when it comes to risk-adjusted returns, which indicate how well a manager has made use of risk within their portfolio, Standard Life Investments UK Equity Income Unconstrained shoots in the top decile for Sharpe, Sortino and Treynor ratios.

Risk models state that not owning a large member of a benchmark is a risk but Moore doesn’t subscribe to this view and argues that risk should only be taken if a manager has conviction in a stock.


 

“A lot of managers think ‘I can’t not hold Royal Dutch Shell, BP and BG because they’re big in the index’. I turn it on its head and say ‘versus cash, Shell is risky’ so being big in the index is neither here nor there for me. Why would I own something that’s inherently risky just because it’s a big part of an index? I take risk, I’m going to take risk in something I believe in.”

This approach has worked over the long term, with Standard Life Investments UK Equity Income Unconstrained posting a 213.34 per cent total return since the manager assumed control. The average IA UK Equity Income fund has made 115.67 per cent over this time while the FTSE All Share is up 107.30 per cent.

Performance of fund vs sector and index over manager tenure

 

Source: FE Analytics

The five FE Crown-rated fund is well respected by analysts. Square Mile Investment Consulting & Research gives the fund an ‘’ rating and said: “For investors looking for a truly actively managed UK equity income strategy which pays little attention to the underlying benchmark then this strategy is most worthy of consideration.”

“With such a high conviction and benchmark agnostic investment philosophy the portfolio will generally look very different to the underlying benchmark and may have much higher allocations in medium and smaller sized companies – though this is not necessarily structural as the manager can allocate to large and mega-caps if they meet his investment criteria.”

Standard Life Investments UK Equity Income Unconstrained has a clean ongoing charges figure of 1.15 per cent and yields 3.68 per cent.

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