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Chris Metcalfe: Why we’re avoiding the highest-yielding sectors from our UK income fund

24 August 2016

FE Alpha Manager Metcalfe, who runs the five crown-rated Newton UK Income fund, tells FE Trustnet why is avoiding some of the biggest and highest-yielding sectors within the FTSE All Share index and how he is positioned for a challenging, low-growth environment.

By Lauren Mason,

Reporter, FE Trustnet

A combination of unfavourable demographics, the continuation of global growth slowdown and distortive monetary policy are just some of the reasons Chris Metcalfe (pictured) has positioned himself entirely differently from his FTSE All Share benchmark.  

The FE Alpha Manager, who runs a number of portfolios for Newton including the five crown-rated Newton UK Income fund, doesn’t hold any banks whatsoever - despite the fact that the All Share has an approximate 8 per cent weighting in this market area - and holds less than a quarter of the oil & gas weighting that the index does.

This is at a time when, year-to-date, the FTSE All Share index has returned 11.63 per cent which is more than eleven times the amount it returned throughout the whole of last year and more than nine times its return throughout 2014.

Despite the index’s strong performance though, Metcalfe has still managed to beat its returns so far this year while holding an entirely different portfolio of stocks, having returned 14.18 per cent and placing it firmly in the top decile versus its sector average.

Performance of fund vs sector and benchmark in 2016

 

Source: FE Analytics

The manager says that, while the FTSE is performing strongly now – partially as a result of ultra-loose monetary policy and currency weakness – investors shouldn’t become too comfortable and assume that this trend is set to continue.

“Obviously [quantitative easing] is good news for asset prices and it’s been good news for gilts and equity prices and maybe it keeps the property market going but, ultimately, what it doesn’t seem to be doing is getting the cogs of economic growth going and getting the multiplier effect going,” he explained.

“Yes it’s good if you just look at the angle of asset price inflation but it’s not really leading to any increase in economic growth in any economies round the world - corporate profit growth looks fairly lacklustre, employment doesn’t look that great and CPI is fairly dull as well.”

Metcalfe says there are a number of headwinds on the horizon for UK investors which have been on the cards since before Brexit. In fact, the manager didn’t reposition the portfolio at all either in the run-up to the EU referendum or after the result was announced.

For instance, he warns that there is a lot more global debt in the system now than there was during the financial crisis of 2008, both in developing and developed economies.

“We think there are a series of deflationary challenges around. There’s a debt drag on growth, there are demographic challenges in terms of the ageing population in most economies around the world, with the exception of Africa and India,” he warned.

“If you look at Japan, Eastern Europe, China, Western Europe and the States, they’ve all got ageing populations. There’s also increasing global competition and one thing quantitative easing does is keep some sick companies going, which leads to more competition and certainly competition around the world is pretty intense. So, you have to try and find companies that are not subject to that.”

“Also, in the UK, e-commerce as a percentage of total retail has now gone up to 12.5 per cent. We’re one of the leading e-commerce penetration countries in the world after the US which is about 13 per cent. You have to make sure you’re not on the wrong side of that.”

“Obviously you have to be very aware of the economic and financial market distortions that are coming out as a result of quantitative easing. I think all of those things – it’s the debt growth, it’s the demographic challenges, global competition, it’s rapid technological change and the distortions of economic and financial markets which have been bought about by quantitative easing, that investors have to be wary of.”

To minimise the impact of these headwinds, Metcalfe has entirely excluded banks from his portfolio despite the fact that financials count for 22.7 per cent of the FTSE All Share and almost half of these are bank stocks.


This decision is particularly bold considering that the third highest-yielding stock in the FTSE All Share index is HSBC with an annual dividend yield of 7.2 per cent.

As he is running a fund within the IA UK Equity Income space, the manager must earn a dividend yield in excess of 10 per cent of the FTSE All Share index over a rolling three-year period and must not dip below 90 per cent of its yield on an annual basis.

Given that he doesn’t hold any banks and holds hardly any oil & gas stocks (which also account for a significant proportion of the FTSE All Share’s total dividend yield), Metcalfe says his concentrated 40-stock portfolio certainly looks different from those managed by his peers.

Performance of indices over 1yr

 

Source: FE Analytics

“Banks are not really designed for interest rates being as low as they are. The most recent Merrill Lynch survey says that interest rates are the lowest they’ve been for 5,000 years,” Metcalfe pointed out.”

“I’m not confirming that that’s necessarily true, but banks don’t find it easy at a time when interest rates are so low and rates have been cut again.”

“They’re also quite highly leveraged – typically a bank will be 20 times levered, and this is among a backdrop where we don’t really see quantitative easing working in the way that central banks and governments would like it to – i.e, to get economic growth going.”

“We don’t think that the banks probably are the place to be so we have a zero position there.”

Newton UK Income is also very light on oil. The £1.8bn fund has just a 2.42 per cent weighting to the oil & gas sector compared to the FTSE All Share’s 11.44 per cent weighting.

While the likes of Royal Dutch Shell and BP are yielding in excess of 7 per cent and are the fourth and fifth-largest positions in the entire index, Metcalfe believes that it is still prudent for UK income investors to avoid the market area.

“If oil prices stay at their present level, we think it’s likely there could be dividend cuts. Shell for instance has debt that already stands at $75bn, it has to make $30bn of asset disposals following the BG acquisition and we think ultimately, it may have to cut its dividend,” he explained.

“We’re trying to emphasise in the UK income fund the types of stocks that can maintain their dividend in what we think is going to remain a low growth and low interest rate environment.”

“That’s really moved us somewhat away from the oil stocks. Plus, we don’t expect the oil price to be particularly buoyant. Obviously we’ve had a big bounce since the bottom but we don’t necessarily think that’s going to continue in what we see as such a low growth global environment.”

Instead, the manager is seeing the strongest opportunities in media, tobacco and utilities stocks and has the likes of Diageo, the National Grid and British American Tobacco within its list of top 10 holdings.

While utilities and tobacco stocks are often labelled by investors as ‘expensive defensives’, Metcalfe says that today’s challenging environment warrants holding them in a portfolio.


“Yes, there are measures you could look at that would say these stocks have done well and these stocks are trading at somewhat higher levels maybe than has historically been the case. But, when you compare these areas to gilt yield and where interest rates have gone to and the fact that we think they offer resilient yields that will stay where they are, we still think it is right to hold those rather than stocks that we think might have their dividends come under pressure,” he argued.

“Stocks tend to underperform before their dividends are cut, there are lots examples of that from last year if you look at the likes of Glencore, Centrica, Tullow Oil and Tesco. The stocks that did cut their dividends tended to underperform in the period until they cut their dividends, then they might have outperformed afterwards.”

“We prefer to be in those stocks that aren’t going to cut their dividend and they’re going to maintain their dividend, which will enable us to pay our dividend out to unit holders and keep our income level up. We think probably it’s still right to stick with UK utilities and with tobacco against those circumstances.”

 

Newton UK Income, which has almost doubled the returns of its average peer and benchmark Metcalfe’s 17-month tenure, has a clean ongoing charges figure of 0.79 per cent and yields 3.76 per cent.

Performance of fund vs sector and benchmark under Metcalfe

 

Source: FE Analytics 

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