Defensives have seen huge inflows in recent years, partly because investors have been seeking safety in the sector and partly because of their tendency to pay dividends.
UK equity income funds have been particularly keen on tobacco, telecommunications and other defensive stocks, and our research showed in August the high level of dependence of the sector on particular stocks such as Vodafone and BAT.
However, Costar (pictured) explains that from a growth and an income point of view Vodafone – a top-10 holding in 75 per cent of UK Equity Income funds in August – is in serious trouble.
“Vodafone’s customers are going away to Skype, instant messaging and other services so the company’s cash flow is deteriorating.” “This is leading to a systematic underinvestment in its network. But it is still trading at high price. It is an over-valued company with deteriorating fundamentals and a serious chance of dividend cuts in the near future,” he said.
He contrasts this to his fund’s holding CSR, a wireless technology specialist with an improving cash flow and products that are being embedded in more and more devices.
According to FE data, Vodafone is the most held stock among managers in the IMA unit trust and OEIC universe, appearing in the top-10 holdings of 428 portfolios overall. Of the 400 funds in the UK Equity Income and UK All Companies sector, 237 – or 59 per cent – hold the blue chip giant in their top-10. The five biggest funds in the UK Equity Income sector, including Neil Woodford's Invesco Perpetual Income and Anthony Nutt's Jupiter Income portfolios, include it among their biggest holdings.
British American Tobacco (BAT) is another company favoured by income funds which Costar thinks is over-valued.
“BAT is considered to be a bullet proof defensive, but its customers are dying, so volumes are collapsing and they are trying to react by putting up prices, which is not sustainable business model.”
“The regulatory noose is tightening – there are now plain packaging rules in Australia, and Russia recently increased taxes by 800 per cent. The directors have sold £31m of stock and the balance sheet shows nearly 100 per cent net debt to equity,” he said.
BAT is another popular stock with UK Equity Income managers, appearing in the top-10 of 44 per cent of funds in the sector.
As an alternative he points to Standard Life – a company that has been out of favour with the market as it’s a financial stock, but which the manager believes has excellent prospects in the future.
“Standard Life has been considered almost uninvestable in the financial space, but people are living longer and investing more for their future retirement.”
“Standard Life is expanding, RDR is a benefit to its business model, the directors are buying stock,” he continued. “It’s feasible it could be taken over as well at its current value.”
Mark Costar has managed the JOHCM UK Growth fund since it was launched in November 2001.
Data from FE Analytics shows that over the past ten years it has significantly outperformed its IMA UK All Companies sector and FTSE All Share benchmark, returning 157.08 per cent over the decade.
Performance of fund versus sector and benchmark over 10yrs
Source: FE Analytics
It’s three-year figures are less impressive, pushed down by returns in 2010 and 2011 that were in the bottom quarter of the sector.
This may be due to the fund’s more aggressive positioning; Costar and co-manager Alex Savvides seek to pick undiscovered or mis-priced growth assets, buying companies that they expect to be re-rated in the future.
Savvides has co-managed the fund since 2008, and the pair also co-manage the JOHCM UK Dynamic fund.