A focus on cash flows and growing dividends saw Aberdeen Standard fund manager Thomas Moore’s UK income fund return to outperformance during 2017 after the strategy struggled in the aftermath of the EU referendum.
After a challenging 2016, when Moore’s £1.3bn Standard Life Investments UK Equity Income Unconstrained fund lost 4.1 per cent and ranked the bottom of the IA UK Equity Income sector, the fund rebounded last year.
Unlike some of his peers, Moore hunts lower down the market capitalisation scale in his search for high-yielding stocks, making use of Aberdeen Standard’s research capabilities including the tools developed by FE Alpha Manager and smaller companies specialist Harry Nimmo.
However, the manager’s bias towards lower-cap UK stocks detracted from performance in 2016 following the EU referendum.
“The portfolio underperformed in 2016 likely because of valuations were re-rated caused by the impact of Brexit,” he explained “Investors decided to jump out of UK domestic stocks and portfolio had more than 50 per cent of revenues coming from those.”
Performance of fund vs sector in 2016
Source: FE Analytics
Yet, the manager’s benchmark-agnostic approach helped boost the fund’s returns last year as mid-cap stocks outperformed blue chips and the fund delivered a top-quartile return of 17.96 per cent.
Indeed, the FTSE 250 rose by 14.65 per cent, compared with a 7.63 per cent increase in the FTSE 100 index, where many UK income managers hunt.
While the fund’s largest holding is dividend stalwart Royal Dutch Shell and includes other blue-chip names such as Rio Tinto, HSBC and BP, Moore’s agnostic approach to market capitalisation is evident in other areas of the portfolio.
As such, just 38.7 per cent of the fund is held in FTSE 100 names, while 43.5 per cent of the portfolio is held in FTSE 250 stocks and a further 11 per cent derives from the FTSE Small Cap index.
This is seen in the fund’s top 10 holdings which include stocks such as Close Brothers, National Express and John Laing.
The agnostic approach also applies to the fund’s sector allocations, with Moore taking a high conviction approach to stock selection.
“Just because pharma stocks are 3 per cent of the FTSE All Share, if we don’t like them we zero weight them,” he explained. “We don’t feel we have to own anything we don’t like. We can take large positions in stocks where we have high convictions.”
The manager focuses on dividend growth as well as companies where there are signs of positive change – helping to drive alpha – and strong cash flows to cover dividends.
Moore highlighted top holding Rio Tinto as an example of a company where he saw positive change in fundamentals as the miner cut its dividend following a difficult period for commodity prices in 2016, forcing it to cut costs and focus on cash flows. It reinstated its dividend earlier this year.
In terms of sectors, the manager has been finding a number of investment opportunities in financials, consumer and resources.
“Those are the three sectors where we are most active; it’s a combination of dividend growth coupled with low valuations,” he explained.
The largest sector weighting in Standard Life Investments UK Equity Income Unconstrained is to financials, representing an allocation of 43.4 per cent and a high conviction area for Moore.
Performance of indices over 5yrs
Source: FE Analytics
“Financials [such as banks] haven’t really taken part in the market rallies over the past five years relative to the market,” he explained.
The case for financial stocks has been strengthened by recent concerns over higher than anticipated inflation in the US and the prospect of faster interest rate hikes.
“If you think about what higher bond yields mean, this is positive for financials,” the fund manager said.
“There are genuine earnings from financials and higher rates means that anybody who holds cash benefits: asset management companies, insurers.”
As such, Moore recently increased his holding in asset manager Polar Capital and finance company Virgin Money.
The concerns over inflation and higher interest rates have also resulted in higher volatility, something that has been missing from the market in recent years.
“I’m quite excited at the moment, we bought on the other side of the market shake-out,” he said. “Common sense will prevail and investors will consider cashflows and dividends.
“In a raising rate environment, I think people will questions growth at any price. Low interest rates have caused companies to re-rate to ridiculous valuations.”
Moore added: “The recent shake-out has been quite helpful, it provides a fresh opportunity to add to holdings at low valuations and I think with the sell-off should come a rotation that will favour our positions.
“Growth has been a very dominant style factor for a number of years. But I think some of the macro changes we’ve seen are likely to drive a rotation away from growth stocks.”
Looking further ahead, Moore said there could be opportunities to be had within the UK market where much of the bad news on Brexit and a potential Labour government appears to be already priced in.
“Brexit hasn’t had an impact on cash flows but domestic stocks still trade at a significant discount to other markets,” he explained.
Indeed, the manager said the UK economy had been much more resilient than some people think, despite the unstable political environment, highlighting low unemployment and continued growth.
Under Moore, Standard Life Investments UK Equity Income Unconstrained has returned 255.90 per cent compared with a 104.57 per cent return for the average IA UK Equity Income fund, as the below chart shows.
Performance of fund vs sector under manager
Source: FE Analytics
The fund’s long-term strong track record has seen it backed by financial advisers with inclusion on the Adviser Fund Index (AFI) series.
“The fund has successfully outperformed its peers in the sector as well as the UK equity market in the last four years,” analysts at FE Invest noted. “Stock selection was the main driver of performance.”
Standard Life Investments UK Equity Income Unconstrained has an ongoing charges figure (OCF) of 1.15 per cent and a yield of 3.67 per cent.