In a world seemingly powered by rising share prices in the US and talk of a fourth industrial revolution of intelligent robots, electric vehicles, mobile supercomputing and gene editing, investors in traditional UK equities could be forgiven for feeling a bit left behind.
That might have been especially true since the Brexit vote in June 2016. The fall in the pound has given overseas earners a lift, while investors in predominantly domestic UK companies have been left to mull over the effects of rising inflation on UK consumers and weakening growth forecasts.
Such thoughts naturally lead us to re-examine UK equity income funds. It’s not easy to be definitive about these funds as a group, but income and value investing, by necessity, have a lot in common. Today a bias to companies paying higher than average dividends implies a decidedly domestic slant.
A brief look at the UK’s top dividend payers might say otherwise. Just a handful of FTSE 100 firms –Shell, Vodafone, HSBC, BP and British American Tobacco – accounted for just over a third of all the UK dividends paid out in the third quarter of last year, and these are all highly international companies1.
However, equity income funds have to be about much more than such a small number of companies. They must diversify to reduce risk to both capital and income and that usually means forays into contrarian or value parts of the market.
So what might be the catalyst for a turnaround in the relative fortunes of value investing?
So far, a partial recovery in the pound versus the US dollar hasn’t been it. Large UK companies with multinational exposures have continued to steal the limelight boosted, perhaps, by upgrades to global growth2.
One thing we do know though is that the political stakes will be high in 2018. In just over a year’s time, we will know pretty much what the UK’s future relationship with Europe will be.
The upside to that is the potential for markets to rebuild some measure of certainty into UK share prices as we move nearer to March 2019. Markets hate uncertainty and any emergence of concrete parameters about future trading relationships could reduce the international discount apparently being applied to UK shares.
If the value bug bites, who knows where it might lead, but equity income investors will be hoping for a substantial upward rerating. Yields of 5.5% and 5.8% respectively for the oil majors BP and Shell still seem a lot for international companies with high quality assets3.
True, US$70 oil is not just a straightforward positive for them, as their profits come from refining as well as sales of crude oil products. However, at a time when 10-year gilts yield only 1.5% and offer no chance of capital growth over time –they are already trading above their values at maturity – equity yields like these look tempting4.
Real estate companies also look cheap, given that well established names currently trade well below the value of their assets. British Land, Hammerson and Land Securities all fall into this category5. We would have to see a substantial drop in commercial property values or rents or both for that to make sense on a sustained basis.
We all know that traditional UK retailers are having a hard time of it, with customers moving online and substituting some of their weekly shop with trips to the German discounters and factory outlets. These are structural issues that are tough to fix.
What’s more, inflation of around 3% – and considerably more than that on individual items – continues to outstrip average wage gains.
However, inflation is set to fall later this year as previous price rises drop out of yearly comparisons. Moreover, a stronger pound should be reversing some previous input price pressures. Developments like these could lead to a refocusing on UK retailers whose shares have suffered a torrid time of late.
One of the risks to a domestically focused strategy is that the pound fails to make further headway or reverses some of its recent recovery against the dollar. The Bank of England seems unlikely to come to sterling’s rescue, being predisposed to keeping interest rates low in case Brexit risks crystallise into something worse.
There’s also the possibility that investors will continue to de-emphasise UK assets viewing growth prospects overseas as simply much better. However, you can only stretch elastic so far and, at some point, equity income funds will be among those lying in wait. Undervalued assets have the potential to dampen the effects of reversals in momentum driven markets and pay attractive dividends in the meantime.
Fidelity’s Select 50 list of favourite funds includes two UK equity income funds run by experienced managers who have lived through many previous investment style cycles.
First, there’s the JOHCM UK Equity Income Fund, a good example of a fund where an emphasis on higher yielding stocks coincides with a contrarian investment style. Here, along with the big FTSE 100 dividend payers you might expect to see among an income fund’s largest holdings, you’ll find substantial positions also in the insurer Aviva and broadcaster ITV.
The Fidelity Enhanced Income Fund builds on the underlying dividends offered by its already high-yielding shares by selling the option to buy some of its shares to other investors. The premium it earns by doing this results in a yield of more than 6% currently, although this is not guaranteed.
1 Capita Dividend Monitor, Q3 2017
2 Cboe Europe, Brexit 50/50 Indices, 30.01.18
3 Bloomberg, 30.01.18
4 FT, 29.01.18
5 London Stock Exchange, 30.01.18
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