Unilever, BAE Systems and Inmarsat are three companies that Aviva Investors’ James Balfour has made big calls on this year as the UK equity income manager continues to focus on the best domestic companies.
The manager of the four FE Crown-rated Aviva Investors UK Equity Income fund said he has made some big changes to the portfolio in 2017 despite the fund being a generally low turnover proposition.
“We don’t turn over the fund that much,” he said. “We are trying to be long-term investors as that should grow both the capital return and the dividend over time.
“We are always looking for new ideas but if we have picked the best companies that is where the focus remains.”
If new companies are to be added to the fund or disposed of, Balfour said, something has to have changed fundamentally in the investment argument.
This may come in the form of management changes or a shift in strategy but it must also be matched by certainty that the dividend is secure and an attractive valuation.
The £966m fund, which Balfour co-manages with Chris Murphy has been a top quartile performer over three years and is ahead of the IA UK Equity Income sector and FTSE All Share over five and 10 years.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
Since Balfour joined the fund in 2016 it has returned 22.3 per cent, 29 basis points ahead of the sector but 4.57 percentage points behind the benchmark. The fund has a yield of 3.66 per cent and a clean ongoing charges figure (OCF) of 0.81 per cent.
Sold
The most recent disposal from the fund was London-based, satellite telecommunications company Inmarsat, which had been a portfolio holding for several years.
“We had been toying with [selling] it last year as the share price had rolled off a long way,” Balfour said. “But it was one of those ones where previous fund managers had experience that when people give up on these [type of] names, sometimes it is the best time to invest.”
Performance of stock over 2yrs
Source: FE Analytics
“We went away and did some work and found out that it has basically always had a volatile capex [capital expenditure] cycle,” he said.
“It was going to invest £500m over the next three years and then they won’t invest anything for the next three years.”
While this had been a regular occurrence for the company, it meant that for income investors there were periods where the dividend appeared well covered and others where it was not so well covered.
“Your dividend payments don’t look like they are covered [for three years] and then they do so there is a cycle around those payments,” the manager noted.
However, the most worrying sign as investors was that the market had begun to change, said Balfour, with more capex needed than ever before on new technology and to keep costs low.
“The capex was always going to have to be high and therefore where the free cashflow was going is not what it used to be in the business,” he added.
The marketplace has changed also, said the manager, with new competitors able to put satellites into space much cheaper, meaning Inmarsat would need to continue investing to keep pace.
Finally, said Balfour, the company’s reliance on the marine sector for some of its revenue was a concern, as the area has been in decline for a number of years, impacting Inmarsat’s returns.
“So, there were a couple of things there where we decided that the profile of this company has changed from what we first invested in,” Balfour said.
“Yes, they held their dividend when people thought it would be cut which was taken well on the day but actually the profile of being able to pay that dividend going forward does look a bit tougher so we took the position out.”
Held
One company that the managers have stood by and kept in the portfolio is consumer goods manufacturer Unilever, despite some outside concerns about valuation and growth prospects.
The company was the recipient of a short-lived takeover bid by US peer Kraft-Heinz, which spied an opportunity to benefit from inefficiencies in the Unilever business.
“We held it but we actually topped up because we saw it as a bit of a kick up the backside of the Unilever management on the day after the Kraft deal fell through,” the manager said.
“Typically, I would use the line [of] don’t invest on the day of either a profit warning or something big like this – where a company is bid for – because you are making a potential rash emotional decision and you have to be rational about these things.
“But we have always liked the business and this was an opportunity where management were going to have to do something,” he added.
“If you are going to rebuff Kraft you have to accelerate and Kraft basically came in and said they were going to use Unilever’s balance sheet to fund buying them so there was clearly something that needed to be invigorated in the Unilever model.”
The company, which the manager referred to as “a bit of a sleeping giant”, has been doing very well over the last decade during which it returned 283.61 per cent.
Performance of stock over 10yrs
Source: FE Analytics
“We took that decision it should be accelerated and that should be good for the stock going forward and if it livens them up to spin off some stuff in the portfolio which they had often talked about but never quite done then that to us was a good opportunity to go in,” Balfour added.
Bought
Lastly, the manager highlighted £20bn global defence specialist BAE Systems as a company it had added to this year from a very minor position to a 1.9 per cent holding in the fund (as at 31 July 2017).
The defence, aerospace and security specialist has been a solid performer in recent years, returning 142.6 per cent over the last five years.
The company peaked at the start of the year as investors grew bullish over the outlook for the company based on US president Donald Trump’s election promises to increase defence spending.
“He sits in the US and is a bit of a ‘loon’ but Trump was always going to provide that defence spending floor,” Balfour said. “We saw that as potentially being a bit of momentum through there.”
Since then the company has slipped back as the market grew more concerned that the US president may not be able to push as many reforms through as he originally thought.
Performance of stock over 5yrs
Source: FE Analytics
However, Balfour said there are other factors that make the company attractive, particularly its valuation when compared to US peers.
“Valuations in the US … got really high but actually the valuation of BAE is on a record discount to those names,” he said.
Additionally, increased M&A activity in the sector has made it even more attractive, he said, with two deals in the sector announced in the last month.
“That was the sort of thing that we thought was going to come through and we wanted to add to BAE,” Balfour noted.