A return to central bank normality has shaken markets this year but it just means that there are now more opportunities and valuations are no longer a concern, according to JO Hambro’s Clive Beagles and James Lowen.
Over the last 18 months it has become clear that central banks in the US, UK and Europe have begun the process of policy normalisation with the ending of quantitative easing (QE) and rising interest rates.
“The true distortive impact of effectively zero interest rates in the developed world on various asset classes will only become apparent in future years,” the managers of the JOHCM UK Equity Income fund said.
“However, it has undoubtedly pushed valuations of many assets and individual instruments to elevated levels that will be hard to justify if the cost of capital rises.”
It should have come to the surprise of no one therefore that markets suffered a correction at the start of the year as stronger data from the US caused investors to fear that interest rate rises may be more frequent than initially predicted.
Performance of indices over YTD
Source: FE Analytics
Indeed, as the above chart shows, the major indices are all in negative territory year-to-date with the UK’s FTSE All Share the worst affected, down 7.19 per cent in sterling terms.
“As expected, markets are finding life tougher at a headline level as this adjustment in bond yields feeds through,” the managers said.
However, the recent bout of volatility has helped JOHCM UK Equity Income’s relative performance, which despite being down 5.54 per cent so far this year is a top quartile performer in the IA UK Equity Income sector.
“The shape of the market’s performance has modestly helped the fund’s relative performance, but the general downward direction of the market and higher volatility have also led to a number of our holdings falling to levels that mean that the valuation signal is now flashing green,” they said.
“Consequently, there are few stocks in the fund that we are concerned about from a valuation risk perspective.”
Indeed, the £3.4bn fund remains on a low price-to-book, both in comparison with its history and the wider market, having only been sustainably cheaper in 2009 immediately after the financial crisis, Lowen and Beagles added.
It has also allowed the managers to add a new stock that they had been “shadow boxing” for around 18 months – supermarket chain WM Morrisons.
While the stock has been “fundamentally attractive” for this time, it has not met the fund’s strict yield criterion and was too expensive.
Over the last 12 months however, the stock has fallen 8.64 per cent, with particularly poor periods before the full-year results in mid-March and in the wake of the annual numbers.
Performance of stock over 12 months
Source: FE Analytics
“This created a more attractive entry point from a valuation perspective, with the stock trading on a free cash flow yield of circa 8 per cent,” the managers said.
“The management also articulated a new dividend policy alongside the results, a move that we had largely anticipated, which indicated that a supplemental dividend would be paid, likely every year. On this basis, the dividend yield is over 5 per cent.”
The stock represents one of several moves the pair have made over the past year into domestically focused assets and they have numerous reasons for optimism.
Lowen and Beagles said: “The management team have recovered the position well from the situation they inherited. They have chosen the longer road of rotating a large part of the cost reduction into lower prices, which will drive competitiveness and future volume growth rather than delivering the instant gratification of large step changes in margin.
“Furthermore, Morrisons is the only UK food retailer that is vertically integrated into food manufacturing, which should confer higher margins.
“It has also cleverly done a number of wholesale agreements (e.g. with McColls), which should likewise add sales and profit over the fixed cost base.”
The supermarket chain has no pension deficit, is lowly geared and has the highest value of freehold property versus market cap compared to its sector peers, they added.
Lowen and Beagles have run the four FE Crown-rated JOHCM UK Equity Income fund since 2007 and 2008 respectively.
Since Beagles joined Lowen the fund has returned 185.89 per cent, more than double the FTSE All Share benchmark and IA UK Equity Income sector.
Performance of fund vs sector and benchmark since Beagles joined
Source: FE Analytics
It has made a top quartile return in seven of the last 10 calendar years and is also there for the first quarter of this year.
But the fund's long-term performance is highly correlated to its dividend growth and the resulting absolute level of the dividend – something that has been given a boost since the recent market correction.
“Year-to-date results have been strong and, in aggregate, dividends have exceeded our forecasts,” the managers said.
“As a result, we are able to increase our guidance for fund dividend growth for 2018 from circa mid-single digits to the slightly higher range of 5-7 per cent.
“This remains a prudent view of the current run rate and allows for the risk of a further strengthening of sterling (particularly against the US dollar).”
This estimate assumes a dividend per unit of 17.2p which would give the portfolio a yield of 4.6 per cent for 2018. The fund has a clean ongoing charges figure of 0.79 per cent.