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Why Ruffer thinks your core UK Equity Income fund could crash

27 April 2015

Tobacco, utilities and consumer goods are typically seen as defensive sectors that protect investors on the downside, but Steve Russell thinks they could lead the next severe market fall.

By Joshua Ausden,

Head of FE Trustnet Content

Investors who view large cap defensive UK Equity Income funds as cautious core holdings are in for a nasty surprise, according to manager of the Ruffer Investment Company Steve Russell, who says certain stocks and sectors are no safer than biotech.

Funds such as Invesco Perpetual High Income and Trojan Income have protected investors very effectively during market downturns, most notably during the 2008 financial crisis and 2011 eurozone summer sell-off. These funds are typically viewed as being at the safer end of the equity market, often forming the core of investors’ portfolios.

However Russell (pictured) says the hunt for yield in light of record low interest rates has bid up the prices of defensive high-yield stocks into bubble territory, and is avoiding them in both the Ruffer Investment Company and CF Ruffer Total Return fund – which both prioritise capital protection above all else – as a result.

“We are as fearful as ever,” he said. “We are acutely aware that the hunt for yield across all markets has driven prices higher, but it won’t last forever. We don’t know when it will come, but it will.”

“Equity income is an especially dangerous area as it has an aura of safety, but in our opinion in some cases high yield stocks are just as dangerous as a biotech stock given the prices they’ve been bid up to.”

“We have been increasingly moving out of high income stocks which we now view as extremely dangerous, because it seems that many owners of them see them as risk free. It will all end in tears.”

Russell sees equity income, globally, as an expensive area of the market, but highlights both the UK and the US as particularly overvalued. The manager’s favourite equity market by some distance is Japan, the reasons for which he explained in an FE Trustnet article last week.

He highlights UK utilities as a particularly risky area at the moment. The likes of Centrica, United Utilities, National Grid and SSE are popular holdings with UK Equity Income managers.

“Utilities have made very strong returns under the last government as investors hunt for yield. These could come under a real threat,” he said.

“We’d also highlight some of the more generally defensive names – food manufacturers, tobacco and some consumer goods companies. We have no qualms with the quality of the businesses but they’re being priced as if they are risk free. They’re not sovereign bonds, they’re equities.”

“This is the danger of 0 per cent real interest rates. It’s making cyclical small caps just as risky as defensive income stocks. The mis-prising of safety is one of the big mischiefs of this cycle.”

Of the 90 funds in the IA UK Equity Income sector, British American Tobacco and Imperial Tobacco are top-10 holdings with 39 and 42, respectively. Eighteen UK Equity Income funds, including Fidelity Moneybuilder Dividend, Evenlode Income and CF Woodford Equity Income, hold both stocks in their top-10. They make up more than 10 per cent of Woodford’s portfolio alone.

Centrica is a top-10 holding for four UK Equity Income funds at present, including Leigh Harrison’s Threadneedle UK Equity Alpha Income fund and Trojan Income fund.  It is currently the CF Woodford Equity Income fund’s 13th biggest position, making up just over 2 per cent of assets.

As Ruffer notes, UK income stocks have performed very strongly in recent years. FE data shows the UK Equity Income sector average is ahead of the UK All Companies sector average and FTSE All Share over one, three and five year periods.

Performance of IA sectors and index over 3yrs

 

Source: FE Analytics


Francis Brooke (pictured), who heads up the £2.1bn Trojan Income fund, has some sympathies with Ruffer’s view, even though he holds the types of companies Russell is alluding to. Trojan Income is one of the largest and most popular defensive UK Equity Income options, delivering top decile returns in the down markets of 2008 and 2011.

While he disagrees that traditional quality income stocks are as expensive as Russell suggests, he does think typically defensive companies could fall much further than investors have been used to if and when interest rates rise.

“I agree with [Russell’s argument] in parts, but not in others,” he said.

“We are constantly monitoring the valuation of a basket of the core quality companies we tend to invest in – stocks like Astra, BAT, Centrica, Unilever and so on. Over the past 20 years this basket has traded on an average premium of between 10 and 15 per cent to the wider UK market, so let’s say 13 per cent.”

“They’re actually bang on that premium today. These companies were much more expensive in late 2011 when they were on a 40 per cent premium, and very cheap in 2009 when they were on a 15 per cent discount as the market rallied. Compared to the wider market therefore, they are neither cheap nor expensive.”

“That said, exactly what triggers a fall in the market would impact these companies in different ways. There’s no doubt that utilities and other bond sensitive companies would be more vulnerable if there was a steep rise in bond yields.”

“We saw a little of that in February when bond yields rose quite sharply and utilities were among the hardest hit. They’ve recovered since then, but it was certainly a warning of what could happen.”

Performance of indices in 2015

 

Source: FE Analytics

“If there is a normalisation of interest rates because the world has entered a more sustainable growth phase, then I do sympathise with the point being made. However, if a market fall was as a result of a broader risk-off event, would there be an exodus from quality companies? I don’t think so.”

Brooke says he has skewed his portfolio away from typically defensive companies of late, but his view on the likelihood of aggressive interest rate moves means he isn’t an outright seller of them. 

“We are wary. We recognise the risks and don’t want to have our entire portfolio facing in the same direction,” he explained.

“We are not buying new holdings with these characteristics but we certainly aren’t selling completely out of them. We recognise the need to diversify but we think it will be some time before rates start to move significantly and we always retain a cash balance to take advantage of volatility – this is currently 8 per cent.”


Interestingly, Russell himself doesn’t think interest rates are set to spike anytime soon. He believes central banks will keep real rates in negative territory to help ease their debt burden, and sees high levels of inflation as a natural consequence of their policies.

He acknowledges that continued loose monetary and fiscal policy could result in the hunt for yield going on for much longer, but has no interest in trying to ride what he sees as a very dangerous wave.

Asked if interest rates will remain low over the next year, Russell said: “Probably, but this isn’t the important question. The most important fact is that real interest rates will stay extremely low if not negative.”

“From our point of view, the fact that there has been so much focus placed on deflation further supports our base case, as it is likely to increase reflationary policies. Inflation falling to zero has resulted in very slight positive interest rates, and central banks are all too aware that the debt burden is actually now increasing.”

FE Trustnet will highlight Russell’s views on inflation in more detail in an article later this week, as well as ways he is looking to protect investors against it.

It’s not just UK Equity Income valuations that are worrying Russell; the obsession with finding yield has also tempered his exposure to UK commercial property, which has become an increasingly popular asset class in recent months.

Russell has some exposure to global property in his open and closed-ended funds, but he currently has none in the UK.

“As far as property goes, we are also looking at regions with 0 per cent interest rates but valuations are far more attraction,” he said. “All of our exposure is via Germany and Japan, which have been core real estate plays for five years or so.”

“In the UK we did have some exposure to properties in Birmingham which have double digit yields, but these have been driven down as investors have looked beyond the UK.”

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