Investors need to avoid UK large-caps in order to find strong total returns and dividend growth in 2016, according to Thomas Moore (pictured), who has managed to increase the five crown-rated Standard Life Investments UK Equity Unconstrained fund's pay-out in every year since he has been at the helm. 
The manager admits that 2016 is likely to remain tough for UK investors seeking dividends and, certainly, concerns have mounted towards the concentrated UK equity income market of late.
On the one hand, many warn that the likes of mining and oil companies (which have high yields) may be forced to cut their dividends due to falling cover and poor earnings growth.
On the other, safe and reliable income-paying stocks – sectors like consumer staples, which have been dubbed ‘bond proxies’ due to the perceived safety of their pay-outs – are now expensive and are offering very little in the way of yield.
Performance of indices over 3yrs
Source: FE Analytics
“At the moment, by buying large-caps you are either taking valuation or balance sheet risk,” FE Alpha Manager George Godber said last year.
However, to avoid this risk, Moore is switching focus away from ‘bond proxy’ type stocks and large-caps with precarious balance sheets and focusing further down the market cap spectrum to ensure he can maintain his track record of consistent dividend growth.
Currently, his £1.1bn fund has fairly equal weightings between FTSE 100 and FTSE 250 stocks at just shy of 45 per cent each, with the remaining 10 per cent allocated to small-caps.
While this weighting has remained reasonably consistent throughout his seven-year tenure, the manager says that his holding in smaller companies at the moment is higher than it has been historically.
“It really is a function of finding these underlying stock opportunities, and it's true to say that we're seeing the best growth opportunities within UK and European consumer names, and those tend to dominate the mid-cap and small-cap space,” he explained.
“The bulk of the fund is invested in mid and small-cap and within that there is a bias towards consumer names.”
Currently, the fund has a 9.5 per cent weighting in consumer products. Moore says that, from a macroeconomic perspective, the growing divergence between consumer and manufacturing regions sparked by China’s slowdown has led to global deflationary headwinds.
He says this has had an impact on the global demand for commodities and as such, companies in mining, oil & gas and industrial sectors have suffered. Conversely, UK consumers have benefitted as a result of lower inputs costs and the improvement of disposable household income.
As such, the manager is seeing the best opportunities in the real estate sector as well as consumer discretionary, as a result of lower unemployment rates boosting loan growth.
One company that has contributed to Standard Life Investments UK Equity Unconstrained’s stellar performance in 2015 according to Moore is Galliford Try, the FTSE 250-listed construction and housebuilding company that has more than doubled the performance of its index over the last year.
Performance of stock vs sector over 1yr
Source: FE Analytics
On top of that, companies such as Staffline and Supergroup have helped drive both his income and total returns.
“Typically these are the names that have been doing really well. They’re consumer names, there’s been a pick-up in activity so we’re not having to worry about what’s going on in China. We’re holding these names with an improvement in their fundamentals, and we’re not having to spend our lives worrying about the slowdown in one of the world’s largest economies.”
While a larger proportion of the fund is held in FTSE 250 and FTSE Small Cap stocks, Moore says that there are still “diamonds in the rubble” when it comes to blue-chips. In fact, the fund’s largest holding is currently BT, which has hit headlines recently as a result of its impending acquisition of the UK’s largest mobile phone network EE.
The stock, which has a 4.9 per cent weighting in Standard Life Investments UK Equity Unconstrained, has outperformed the FTSE 100 by more than nine times over the last three years, providing a total return of 109.8 per cent.
Performance of stock vs index over 3yrs
Source: FE Analytics
“It’s not impossible to find attractive large-cap names,” Moore said. “It is hard work though because a lot of these companies have legacy issues – they have drags on their growth from having invested badly in the past or from being exposed to low growth areas, so it’s difficult finding good growth opportunities within the FTSE 100 but there are still some out there.”
Another area of the market he is seeing income opportunities in at the moment is the financials sector within the small and mid-cap space.
“I think within financials there are winners. When you mention the word ‘financials’ people tend to assume you’re talking about banks, but I think banks are the exception and there are still headwinds for banks from legacy issues such as the need to build up capital for regulatory purposes, and fines and litigation,” Moore explained.
Moore says the reason he has been able to grow his dividend each year since he took over the portfolio in January 2009 is because he has been able to find the smaller, more nimble companies which are off the radar for most of his peers.
Standard Life Investments UK Equity Income Unconstrained’s dividend history
Source: FE Analytics
“It’s trying to redeploy that capital into names with much faster growth,” he said. “The beauty of that approach is that you don’t have to wait very many years, and even with a low yield, if you start off with a company that is only yielding 3 per cent, the market might be yielding 4 and GlaxoSmithKline might be yielding 5, but it’s not worrying about buying stocks with a relatively low starting yield.”
“This is because if it grows its earnings by 15 per cent per year and the pay-out ratio stays the same, on your book cost you’ll find that the yield you’ve generated on that investment has matched a stock like Glaxo with minimal dividend growth within three or four years.”
“You get this rising share price suddenly and, as the dividend grows, you’re not having to churn your portfolio and you’re able to maintain that position and generate a growing dividend stream.”
Over Moore’s tenure, Standard Life Investments UK Equity Unconstrained has returned 214.73 per cent, outperforming its peer average in the IA UK Equity Income sector by 106.37 percentage points.
Performance of fund vs sector over management tenure
Source: FE Analytics
It is also in third place out of the 84 funds in the sector for its performance over five years and is in fifth place for its returns over three years.
The fund has a clean ongoing charges figure of 1.15 per cent and yields 3.87 per cent.
