FE Alpha Manager Alex Wright is trimming the exposure to Lloyds in his Fidelity Special Situations fund and using the money to buy more shares in Royal Bank of Scotland, saying the progress made by the former over the past couple of years means it offers less upside potential for investors
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Wright (pictured) currently has 34 per cent of his portfolio in financials, with a 4 per cent overweight position in banks compared with the FTSE All Share.
While banks in particular tend to do much better in an environment of higher interest rates, Wright said that his holdings are not reliant on an uptick from the current rate of 0.75 per cent to deliver strong returns.
He pointed out that even at current levels, they are trading on price-to-earnings (P/E) ratios of between 7 and 8x with dividend yields of 5 to 6 per cent “or in the case of RBS, probably a 12 to 13 per cent dividend yield as it gives back excess capital”.
“Even in the current rate environment, those companies look very attractive from a cash-return point of view,” he said.
“Over the next three years Citi, AIB and RBS can return more than 30 per cent of their market cap to shareholders via a combination of dividends and buybacks [even though] the underlying earnings of the banks are sort of flattish.
“You are still getting a business on 8x earnings, but you are getting a third of your money back. In fact if the capital position doesn’t improve, you are down to sort of 5x earnings, so I think it is the valuation and the cash returns that make the banks look really attractive.”
However, one UK bank that Wright has become less keen on over the past six months is Lloyds, with the manager trimming his position from 4 to 1 per cent and recycling almost all of this capital into RBS.
Wright divides the stocks in his fund into three categories based on where they are in their recovery cycle: ‘stage one’ comprises out of favour companies in which he has identified a catalyst for change; ‘stage two’ is where the turnaround thesis starts to come through, the company starts to outperform and the position becomes bigger; and ‘stage three’ companies are those in which sentiment is so positive that valuation no longer offers significant upside, leading him to sell the position down.
The manager said that while both Lloyds and RBS are ‘stage two’ companies, the former is much further along in its recovery, meaning there is less room for improvement.
Performance of equities since 2007
Source: FE Analytics
“Lloyds clearly has very adequate capital and actually today’s announcement [the Bank of England’s Prudential Regulation Authority set a lower rate for Lloyds’ capital requirements] means it has got even more,” he explained.
“But, generally, it is much more optimised so it has done everything, it has got the provisions down, it has the capital build, it has the costs down.
“So actually… whereas in three years’ time I think AIB [Allied Irish Bank], Citi and RBS are going to have slightly higher earnings, Lloyds is going to have lower earnings in three years’ time on our estimates, because there isn’t any loan growth, margins are coming down and costs are flattish.
“Yes, the valuation is really good and the dividend yield is also really good, but actually earnings are likely to come back on us because provisions are at extremely low levels today and those are probably going to rise over time.”
Aside from RBS, Wright has also used some of the money from the sale of Lloyds to add to his position in life insurer Legal & General, which is another major theme in his portfolio.
The Fidelity Special Situations manager said this is a sector that is going through enormous structural change, benefiting from a recent strategy shift from the Pensions Regulator and the FCA – which has seen “an explosion in demand” for life insurers’ bulk annuity products.
“That is effectively where you have a defined benefit pension scheme, you take the assets of that scheme to the insurance companies and they give you an annuity to cover all the risks there,” he explained.
“Basically, because of all the things we have seen happen with some of the weakly funded pension schemes, the regulator is making a big push to consolidate into much stronger, more closely regulated entities.
“Therefore, instead of there being thousands of companies in the UK responsible for your pension, they want them to be moved to the insurance companies where effectively there are fewer than 10 companies that are highly diversified and the regulator has a close eye on.”
Wright said that what is interesting about this area is that the buyers of these annuities are not price-sensitive: all they are looking for is a strong business that can guarantee it will appropriately service the pensions.
As a result, it is not particularly competitive, and while there are thousands of potential customers, there are realistically only three or four companies that can service the large schemes and six or seven that can service the small ones.
Despite all these tailwinds, P/E ratios remain low, while dividend yields are high – about 7 per cent for Phoenix and Aviva and 6 per cent for Legal & General – which suggests the market is concerned about asset quality.
However, Wright said these companies have been putting to good use the profits they have generated over the past 10 years: he pointed to a simulation of a 2008-style financials crisis, in which Legal & General’s solvency ratio fell from 180 per cent to just 150, where the regulatory minimum is 100 per cent.
Dividend yields and solvency ratios of life insurers
“You can see that these companies are at very high solvency levels,” he continued, “and also because of the asset mix and the global diversification, they are nowhere near as sensitive to asset markets as they have been in the past.
“It is a really interesting space, because you have got higher demand and pricing, with much more solid balance sheets, but the valuations in no way reflect that. And all these three companies are growing the dividend as well.
“Look at the P/Es, these are not being viewed as growth businesses where the margins are increasing and actually they are pretty safe businesses as well.
“This is an area I think is really exciting over the next three to five years. And one I have added to.”
Data from FE Analytics shows that Fidelity Special Situations has made 45.44 per cent since Wright took charge in January 2014, compared with gains of 37.21 per cent from the FTSE All Share and 34.87 per cent from its IA UK All Companies sector.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The £3bn fund has ongoing charges of 0.91 per cent.