Recent depressed investor sentiment on the UK economy and equity market has led to a wide dispersion between the valuations of in-favour growth stocks and their unloved value counterparts.
Growth has been on an incredibly strong run over the past five years, with the MSCI United Kingdom Growth index outperforming MSCI United Kingdom Value by 10.54 percentage points, although the gap has been somewhat narrowed since its widest point in 2016.
Performance of indices over 5yrs
Source: FE Analytics
As such, Scott McKenzie, manager of the TB Saracen UK Income fund, has begun to tilt his portfolio more towards the most unloved area of the market – deep value.
The fund has been the third-best performer in the IA UK Equity Income sector since the start of 2017 following a disappointing first full-year in 2016.
Overall, since its launch in May 2015 it has returned 29.64 per cent, the 10th best in the 80-strong sector, making it the only fund launched in the first half of 2015 across the IA UK All Companies and IA UK Equity Income sectors to produce a top quartile return.
“In the income fund, in the first half of this year we have been buying much more of what I would call deep value shares, which are stocks that we think are very cheap,” McKenzie said.
Conversely, he has been selling stocks that have done very well in the past three or four years and have benefited from the improvement in growth.
Most of these dep value shares have the same characteristics of being out of favour, quite contrarian and (key for an income portfolio) high yielding.
The biggest concern for investors – and managers – looking to implement the deep value strategy is that as the stocks are in decline, choosing between companies that can and cannot turn things around is tough.
McKenzie said he is aiming as much as possible to avoid stocks that are going to cut their dividends as this tends to lead to a poor return at both a capital and income level.
“However, there are some of them where it is almost expected because the shares have been so weak,” the manager said.
One stock that he has bought recently that he believes could be ready to turn the corner is plastic packaging business RPC Group.
The company has had its troubles of late with public anxiety about the environmental impact of plastics and investor anxiety about earnings quality leaving the shares friendless.
This sent the share price plummeting, at one point down 34 per cent from its peak in October 2017, although it has rebounded 17 per cent since its trough in June this year.
Performance of stock over 3yrs
Source: FE Analytics
“We believe that some of the issues could well diminish from here and with the shares trading on a high yield for the first time we see RPC as a higher risk recovery buy,” McKenzie said.
Similarly, flooring distributor Headlam has been on his radar for some time and has previously been in the portfolio.
“The shares have fallen sharply since our previous sale with weaker trading in 2018 so far and poor sentiment towards consumer spending taking their toll,” the manager said.
Indeed, Headlam’s shares have plummeted 17.39 per cent so far year-to-date, yet despite ongoing concerns over the short term, he added that the long-term prospects remain strong,
“The company has good management, a very strong balance sheet and a dominant market position which should allow it to weather such storms. They have a proud dividend record and now offer a high yield after recent falls,” McKenzie noted.
One area that the manager has been topping up recently is financials and in particular the asset managers, which have faced numerous headwinds in the past few years including Mifid II and close scrutiny on fees leading to a rise in passive investing.
“We have a decent slug of the fund in financials but it is not in banks; I typically have more in asset managers and life insurance companies,” McKenzie said.
The fund has held Jupiter Fund Management and private equity specialist Intermediate Capital since it launched, with both proving to be decent performers over that time, although the former’s share price has fallen back year-to-date.
More recently, he has been buying into Standard Life Aberdeen, which has had a torrid time since the Standard Life and Aberdeen Asset Management completed their merger in August 2017.
Since then, the stock is down 20.98 per cent, as the below chart shows, but the Saracen manager said he sees it as a buying opportunity.
Performance of stock since merger
Source: FE Analytics
He noted: “We have been buying more Standard Life shares recently in both of our UK funds as it is a very messy situation. I find when things are not clear and are quite messy those are the times when you make the best returns but it is not obvious and it is hard work.
“That one I think in due course will come quite good for us. I think it could be a really good stock to own for the next few years.”
He added that the yields on offer from the sector, highlighted by Standard Life Aberdeen on a 7 per cent yield, give some cushion to any potential issues.
“I think there is no risk to the dividend at all there, if anything they will increase it – so I regard it as a great opportunity for income especially,” he said.