A number of UK dividend-paying mega-caps have been unfairly labelled as ‘bond proxies’ and have fallen out of favour creating more attractive ‘buy’ ideas for 2017, according to Troy’s Francis Brooke (pictured). 
The FE Alpha Manager, who heads up the five crown-rated Trojan Income fund, says it is unlikely that bond yields will carry on rising exponentially and warns that global growth may not be as rapid as markets are pricing in.
He says that many so-called ‘bond proxies’ have been sold off in a mass bid for value, despite many of them boasting attractive fundamentals.
“There is a feeling that, when people talk about bond proxies, that label is much too widely used and I think that there are a lot of companies that are regarded as quality defensive companies because they’re very good companies,” Brooke said.
“If you look at their long-term returns on invested capital, they have generated superior returns over very long periods of time.”
The manager says mega-caps with strong balance sheets and steadily growing dividends have been placed into the same category as highly-leveraged, high-yielding stocks that offer little downside protection or capital growth.
“Although they are clearly some parts of the markets like utilities and some highly leveraged property-orientated companies that might be regarded as being highly sensitive to the bond market, I think a lot of high quality defensive companies have been labelled as bond proxies but actually they shouldn’t be,” he explained.
The first half of 2016 saw a mass flight to quality as nerves grew surrounding the EU referendum and the impact this could have on market volatility.
As bond yields reached historic lows, many investors bought into dividend-paying, leveraged ‘stalwart’ stocks in a bid for steady streams of income.
During the second half of the year, however, expectations of fiscal expansion, interest rate rises and a boost in global growth led to a violent market rotation into value plays.
Performance of indices in 2016
Source: FE Analytics
“In these situations you don’t chase the rotation, you say that it is going to throw up more opportunities to buy stocks that suddenly are looking less attractive compared to the sentiments driving markets today,” Brooke continued.
“We have seen this in the past, particularly in 2009 when a lot of the stocks that were really dumped were high quality companies.
“Then they rallied from the lows of the crash and it turned out to be a fantastic opportunity to buy good businesses on much more reasonable valuations and that led to an outperformance over the next two or three years.
“As long as investors are prepared to tolerate short-term relative volatility – which is obviously totally different to absolute volatility – then we feel that tolerance allows the manager to take positions or increase positions in quality companies that will deliver good returns through the cycle.”
Brooke isn’t the only UK equity manager to take this stance when it comes to the ‘value versus growth’ debate. FE Alpha Manager Nick Train, who runs the CF Lindsell Train UK Equity fund, explained in his latest update that he won’t be jumping on the value trade bandwagon despite underperforming the FTSE All Share index in 2016.
“Your strategy has begun to underperform over the last six months, as other investors anticipate a period of higher inflation and sustained upswing in commodity prices,” he wrote.
Performance of Trojan Income fund vs sector and benchmark in 2016
Source: FE Analytics
“This anticipation has encouraged a rally in the ‘value’ and ‘cyclical’ sectors of the UK stock market to which we have little or no exposure and never have had.
“We have no particular view as to whether this ‘new’ economic outlook will prevail, but would not change the current disposition of the portfolio even if we did.”
Brooke questions whether this rotation will last over the long term and believes market movements are too rash in terms of growth prospects and yield curve movements.
“Our view is that the sudden swing towards the normalisation of the interest rate curve and rising yields across the yield curve is probably a little bit overdone now,” he said.
“We think they are probably going to rise, but whether that is sustained at the going rate is something we are a bit more cautious about.
“We think there are still some issues around growth in the world which are going to make it more likely that things could slow down a bit after an initial burst of activity.
“That is one of the reasons why we’re more comfortable to be with the quality stocks because we think that, actually, although this rotation has been quite powerful, that we’re not convinced that is going to be sustained indefinitely.”
The fund’s cash weighting currently stands at 8.4 per cent, which is lower than it has been in previous years.
He has been using the growth/value rotation to top up existing positions in the likes of Unilever and Reckitt Benckiser, both of which have struggled over the last six months.
Performance of stocks over 6months
Source: FE Analytics
Other stocks that he believes could be mislabelled as bond proxies in the portfolio include DairyCrest, British American Tobacco and Imperial Brands.
“Valuations are a bit lower than they were six months ago but it hasn’t changed massively. We’re on the lookout for new opportunities,” the manager said.
“There are a few things coming onto the radar screen that maybe weren’t there early last year when everything got very expensive.
“Fulfilling our contract involves generating total return but also growing income and we’re very committed to both.
He added: “I think, at a time when income is hard to come by, a high quality stream of income coming from a portfolio that is considerably less volatile than the average, is not a bad place for investors to keep their capital.”
Over the last decade, the £3.2bn Trojan Income fund has almost doubled the return of its average peer and significantly outperformed its FTSE All Share benchmark with a total return of 126.64 per cent. It has done so with a top-quartile annualised volatility, downside risk and maximum drawdown (which is almost half that of its benchmark).
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
If an investor had placed £1,000 into the fund a decade ago, they would have received £456.24 in income alone.