While UK equities remain out-of-favour, investors who underweight the sector could be missing out on an asset class that offers a significant yield premium to gilts and other fixed income assets, according to portfolio managers at OLIM Investment Managers.
The popularity of UK equities among investors has fallen dramatically since the EU referendum of 2016, which signalled that the majority of voters favoured exiting the bloc.
The widely-read Bank of America Global Fund Manager Survey reported that the UK remains respondents’ “least favoured region”.
As the below chart shows, allocation to UK equities remains a significant underweight among international investors “as Brexit remains unsolved amid conservative party leadership election”.
Source: BofA Merrill Lynch Global Fund Manager Survey
However, Andrew Impey and Patrick Harrington – part of the four-member investment management team of OLIM, a subsidiary of Albion Capital – said that the UK market is currently pricing-in scenarios that may or may not happen.
“The current market is certainly discounting some pretty severe economic conditions, which we’re not actually experiencing,” said Impey.
The pair who, along with the other team members—co-founder Angela Lascelles and assistant manager Henry Bottling – co-manage the SVS Albion OLIM UK Equity Income fund, believes the UK is currently trading at a significant discount.
Therefore, they argued, there are considerable opportunities in the UK market for selective investors to unlock value given Brexit discount and weak sterling, despite high levels of overseas earnings.
“We think this market offers quite an opportunity,” Harrington said, “just as everyone is taking their money out of the market.”
Harrington, who said he is “more optimistic about the UK economy than consensus,” added that the economic situation is better than one might think by reading the press.
While Harrington acknowledges that “Brexit has been a lot more difficult than expected,” neither he nor his co-manager share the pervasive gloom about the UK’s withdrawal from the EU.
Harrington said sterling provides a ‘safety valve’, noting: “If Brexit gets difficult, the pound will go down. If the pound goes down—with two-thirds of the profits in the stock market coming from overseas—those companies instantly become more valuable.”
He said that there’s strong statistical evidence that “when your currency goes down a lot, your stock market goes up a lot”.
He added that a weak sterling would boost exports and encourage tourism.
A bigger risk, the two managers agreed, is “our friend Jeremy Corbyn,” though Harrington doubted the Labour party leader could win a majority should a general election be called ahead of the fixed term parliament due to expire in 2020.
Performance of euro & US dollar in sterling terms since EU referendum
Source: FE Analytics
“But it’s a risk one has to be mindful of,” Impey said. “It makes you worry more about the gilt going down, with a ‘spend, spend’ government issuing bonds.”
Harrington said he’d rather be in equities in the event of a Corbyn-led government.
Meanwhile, the team continues to control risk “in a slightly unusual way”.
“Our portfolios are more broadly spread than the market as a whole, so we have no more than 10 per cent in any one sector,” Harrington said. “Because we believe that by having that wider spread, you’re exposed to a greater number of influences.”
He said this means that despite the high yield of the portfolios, they are no more risky than the market as a whole.
The SVS Albion OLIM UK Equity Income managers divide the market into sectors among themselves for coverage purposes. “We’re stockpickers, bottom-up led,” Impey said. “The weighing of a sector is a function of the stock we find in it that we like.”
Impey explained that the team does not avoid any sectors per se, although they may limit exposure to sectors.
However, “the sort of things we don’t particularly like include contractors and others in the construction sector”. He said these stocks seldom tick a strong balance sheet and often have very long-term liabilities.
The team also tends to be underweight banks, he said, because they have a huge job rebuilding their balance sheets. “That’s generally being done now in the UK and the US,” Impey noted. “It’s Europe that still has a significant problem in that area.”
The managers do like the insurance sector, however.
“They tend to have decent yields,” said Impey, referencing Legal & General. “The market really hasn’t liked this company for ages,” Impey said, noting the 3.4 per cent holding. “But it’s been growing a high dividend of 10 per cent per annum.”
The portfolio manager said they’ve had great success in the non-life insurance sector, such as Beazley, a specialist insurance business.
“We’ve had Beazley for a while. It’s running yields of only about 2 to 2.5 per cent, but it pays a lot of special dividends.” He added that Beazley has by now yielded more dividends than the cost price.
“The insurance sector has been pretty good for us,” Impey said. “Mainly because of the companies, not the sector.”
Harrington said the reason why the insurance sector is in such a great shape today can be traced back to the Equitable Life scandal, involving promises to policyholders the company could not afford to keep.
“After Equitable Life, regulations toughened up a lot. So, when the financial crisis hit, one or two [companies] in the sector cut dividends, but there was no support from the government, and they all go through it,” he explained.
“Compare that to banks, where Lloyds and Royal Bank of Scotland partially had to be nationalised, Barclays had to go cap-in-hand to the Middle East, and Standard Chartered had to have a very large rights issue.”
Harrington said the insurance companies have been tested in the most extreme financial circumstances and found to be okay.
“On top of that, there’s another regulation which is European-inspired called Solvency II, which basically added another layer of capital,” he said. “So, what was already a strong regulatory regime is now even stronger.”
Other successful investments by the team include Devro, one of the world’s largest sausage-casing makers, whose “shares are lowly rated,” even as the company returned to dividend growth last year.
Packaging manufacturer DS Smith – which specialises in corrugated cardboard packaging for fast-moving consumer goods companies—is another example.
“The company has leading market positions in Europe and the US and has consistently grown ahead of the wider market,” said the portfolio managers.
The SVS Albion OLIM UK Equity Income fund is a high-conviction portfolio with 30 to 40 holdings, the fund “stays away from illiquid stocks, and always with the dividend”.
“We try to look for high-yielding companies that are actually growing their dividends,” said Harrington. “This suggests the business is growing and that they are generating enough cash to pay those dividends.”
The value investors with an income focus acknowledge that both value and equity income are currently out of fashion. “But we do feel there are particular opportunities for both in the UK market at the moment,” Harrington said.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
The £21.2m SVS Albion OLIM UK Equity Income fund has returned 241.43 per cent since its 2002 launch, against 197.86 per cent for the IA UK Equity Income peer group and a 198.31 per cent rise for the FTSE All Share benchmark. It has a yield of 3.98 per cent and ongoing charges figure (OCF) of 1 per cent.