Brexit-inspired bearishness over UK stocks focused on the domestic market is creating opportunities for income investors, according to Fidelity International’s Michael Clark (pictured). 
The portfolio manager of the four crown-rated, £1.1bn Fidelity Moneybuilder Dividend and £542m Fidelity Enhanced Income funds, says the reaction to last year’s referendum result may have been overdone.
He said: “In the past year, one of the main events for investors has been the devaluation of sterling following the Brexit vote.”
Performance of sterling vs US dollar over 1yr
Source: FE Analytics
Considering the trade-weighted index of sterling, Clark says while devaluation has been “very significant” since the referendum, it had not fallen as much as in 2008.
Clark says the sterling weakness is likely to contribute to inflation, which is expected to peak at 3 per cent this year.
However, the manager argues that it unlikely to reach 5 per cent as seen in 2008, which was driven by a hike in VAT and higher oil prices.
He said: “There is a level of inflation and sterling weakness. Sterling weakness is, in a way, very beneficial to investors in the UK market because the UK market is very international.
“Foreign earnings are worth more in pound terms with weak sterling.”
Clark said bearishness on the UK economy as negotiations begin to define its future relationship with the EU, it’s largest trading partner, was not reflected in growth forecasts.
He explained: “GDP growth in UK has remained strong. Forecast for GDP growth in current year is 2 per cent. It has been better than that momentarily in the past few years but it’s a pretty good number.
“Yet there has been very significant level of scepticism in relation to UK economy and stocks.
“If you consider that the P/E [price/earnings ratio] on the market as a whole is 15 [times] that’s a market that includes international stocks that aren’t subject to any negative effects of what’s going on domestically.
“Any UK stocks very much focused on UK market have gone to big discounts to 15 times earnings.”
Clark says he has recently taken positions in undervalued stocks with a greater focus on the UK economy, such as insurer Legal & General, Lloyds Banking Group, retailer Next and transport company Go-Ahead.
The manager says these are examples of UK stocks that have drifted to big discounts as result of scepticism around UK economy that “doesn’t seem to be justified”, noting that the firms have good yields that are well-covered.
“I think UK domestic stocks are undervalued,” he said. “I know there are concerns about the UK economy but I think these concerns go too far.”
Beyond the undervalued domestic-focused stocks, Clark recently backed consumers staples giant Unilever, based on a “revolution” underway in the sector.
While not expecting the approach from Kraft Heinz, which boosted valuations, Clark says there had already been indicators of the potential for long-term growth
Performance of Unilever YTD
Source: FE Analytics
“There is a revolution in the air. The price of baked beans and tomato ketchup hasn’t increased but the operational margin of Kraft Heinz has gone from about 18 per cent to 30 per cent by eliminating corporate excess and taking out costs, general admin costs and reducing staff within the business,” he said.
“The margin gap they have created there was the main reason for [investing in] Unilever: Unilever could do the same thing.
“The bid won’t go through but what will happen in my view is a concerted effort by the management to increase margins in the business.”
He added: “They have said that margins will got to 20 per cent by 2020, but I expect them to go beyond that over time.
“Returns for of shareholders in consumer staples will rise and will get a powerful beneficial effect of cost cutting in a strong non-cyclical business.”
Another stock being backed by the manager is UK pharmaceutical company GlaxoSmithKline, which he says after having been worried about he has now backed.
“It is a diversified pharmaceutical business. They have new management, they are focused on vaccines and consumer products as well as prescription drugs,” he said.
“They’re present in developed and emerging markets. Cash generation is strong and has actually improved over the past year or so and I think the dividend is secure.
“This is also undervalued relative to many other pharmaceutical stocks, I believe it has low risk, stable income and will give us a solid return over the next five years.”
One area Clark remains underweight is the oil & gas sector, although this relates partly to his scepticism over FTSE 100 giants BP and Royal Dutch Shell.
The Fidelity manager says while the market situation has improved for both high-yielding companies following an extended period of low energy prices, they remain under stress and he is not convinced by the yields in the longer term.
Elsewhere, the manager remains positive on regulated utilities which should benefit from any rise in inflation and the financial sector, where he also owns HSBC.
Other stocks recently added to the portfolio included property company Hammerson, building products specialist Forterra, high street retailer Marks & Spencer, support services firm Babcock International, technology company Equiniti, and waste management company Biffa.
Disposals by the manager have focused on low dividends supermarket Morrisons and engineering firm GKN or where there have been problems such as manufacturer Cobham or home shopping company N Brown.
He added: “It’s prudent for us to have modest exposure only to those sectors to minimise risk of change in policy.
“We have much more exposure to consumer staples, finance and health are more solid basis for income over time.”
“Economic growth generally worldwide remains strong, prospects appear solid in North America, Western Europe and Asia above all, particularly China.
“It’s very possible to invest through a UK-based fund and gain access to that growth and not worry too much about risks present in the UK around the political situation.”
Additionally, the manger says the recent lowering of the yield requirement for the Investment Association’s UK Equity Income sector will not change how he manages both funds.
“I’m not going to reorganise the portfolio to reflect the rule change: that would result in drop in income because we don’t have to meet the 110 per cent [requirement] in the short term,” he said.
“In the medium term it’s quite a good rule change because what it does avoid sorting fund managers into [a sector of those] who over expose themselves to yields that are too high and subject to risk of dividend cuts. I think it’s a healthy move but doesn’t mean we have to do anything.”
Clark has managed the Fidelity Moneybuilder Dividend fund since 2008. Over three years the fund has returned 31.24 per cent compared with a 26.95 per cent gain for the FTSE All Share benchmark and a 26.36 per cent gain for the average IA UK Equity Income fund.
Performance of fund vs sector & index over 3yrs
Source: FE Analytics
The fund is currently yielding 4.2 per cent and has an ongoing charge figure (OCF) of 0.67 per cent.
The sister Fidelity Enhanced Income fund is co-managed with derivatives portfolio manager David Jehan and uses a covered call strategy to boost yield.
The fund – which is also located in the IA UK Equity Income sector and benchmarked against the FTSE All Share – has generated a 22.87 per cent return over three years.
It is currently yielding 6.5 per cent and has an OCF of 0.96 per cent.