04 Apr 2019
Article | 03 April 2019 | Mark Barnett, Head of UK Equities
Underlying economic and corporate data suggest that the UK economy is relatively robust despite the persistent negativity seen since the EU Referendum result. Bearing in mind the increase in government spending confirmed in the Chancellor’s Spring Statement, coupled with the Treasury’s flexibility to provide further injections after Brexit, it feels reasonable to expect the UK economy to remain resilient.
The themes across the portfolios have remained broadly consistent over the past year. The tilt towards UK domestic opportunities has been emphasised, as persistent negativity towards domestic sectors has created further opportunities. We have taken profits from some of the more internationally focussed companies and reallocated this capital into what are, to my mind, better value opportunities within unloved domestic sectors. For example, the portfolios no longer include pharmaceutical company AstraZeneca, but exposure to British retail and real estate companies Next, Tesco and Derwent London has been emphasised.
Investing in equity markets is inherently risky and nobody can predict with certainty how much further valuations could deteriorate. However, if we look at data from the past fifteen years we can see that the floor (in P/E terms) has historically been around a 30 per cent discount to the wider market. We are experiencing levels of pessimism not seen since the financial crisis:
Source: Barclays as at 31 December 2018. Market = FTSE 350 index.
The inference from this data is that the market is pricing in an impending recession of 3-4 per cent. This feels overly pessimistic and is not supported by underlying economic growth, which has proven relatively resilient.
To my mind, the exposure to UK domestically orientated companies offers the most opportunity within the funds at present. Clarity on our future relationship with the European Union would likely prove a positive catalyst for companies that have de-rated under sustained political uncertainty. Absent a two-year extension, and the additional uncertainty that would come with that decision, it feels we are nearing a point of clarity, if not resolution.
Cheapness. Valuations themselves can become the catalyst for reassessment when discounts become unsupportable. If not, we are likely to see M&A activity. We’ve already seen some of this over the past few months. For example, Dairy Crest, a British focussed dairy business, accepted a bid from Canadian rival Saputo earlier this year.
More broadly, any material uplift in the value of sterling versus international currencies and an end to the Brexit uncertainty could also be potential catalysts for a revaluation of the UK Equity market.
The UK stock market offers one of the most attractive levels of income of all global markets. However, that dividend income is provided by a highly concentrated group of large-cap companies. I am seeking to provide investors with attractive levels of income, from well diversified sources that have the ability to grow over time.
In aggregate my portfolios have slightly lower levels of income than the FTSE All-Share index, but the income is better secured by earnings (dividend cover) and with higher growth forecast (according to Bloomberg consensus estimates). As an example, the table below compares the income profile of the top twenty holdings of the Invesco High Income Fund (UK) with that of the FTSE All-Share Index:
Source: Invesco and Bloomberg as at 21 February 2019. Bloomberg consensus estimates. For illustrative purposes only.
Whilst the portfolios all have a focus on providing income, clearly capital growth is a crucial component of total return. In respect of the portfolios I manage, recent capital growth has been disappointing, relative to the performance of the FTSE All-Share index. As a fellow investor in the funds, I feel the effects of any relative underperformance alongside my clients.
What I would say is that I remain confident in my investment approach and in the opportunities that currently sit within the funds. Despite the volatile and somewhat irrational market pricing we have seen recently, my investment process has not changed. I believe that over time, my positioning of the portfolios will prove correct, and that the funds will be able to deliver both income growth and growth in capital.
Most of the portfolios have some exposure to smaller and unquoted companies. The only exception is the Edinburgh Investment Trust plc, where the board restricts investment in non-listed securities.
Over the past few years we have sought to rationalise the exposure of the funds to unquoted companies, reducing overall levels, in particular removing speculative investments where the likelihood of receiving a meaningful return on investment was deemed to be low.
We have put in place a capital recycling process, whereby any new investment in an unquoted company is only made with the proceeds from earlier investments in this space. This prevents a situation where profits are taken from larger, more liquid stocks, to fund new unquoted investments. Future investments will also only be made as co-investments within “families” of companies, where we can leverage the technical expertise and structure of professional venture capital managers.
Unquoted levels within the funds ranges between 1.5% and 4% of assets (as at the end of January 2019). To put these levels in context, they remain significantly below the regulatory limit of 10% and below the internal limit of 5% +/- 1.5% I apply to all the portfolios.2
At the start of the year the only number you needed to know when investing in the tobacco sector was eight. Companies were trading on eight times earnings and yielding eight per cent. That gives you an idea of the level of negativity priced in to the sector.
It is true that we have seen some relief year-to-date. However, the sector remains, to my mind, significantly undervalued. Negativity really centres around fears of increased regulation in the United States and the outlook for next generation technologies, where the success of industry disruptors like JUUL presents challenges to the existing cigarette business. To my mind, these threats are overplayed, and current valuations offer too bleak an outlook of the industry’s future.
We also cannot assume that the outlook for the sector is homogenous. Volume decline within traditional tobacco may be forecast to continue, but the distinction should be made between companies that can continue to gain market share and those less able to do so. I also think that the market has struggled to read across the opportunity presented by next generation technologies, which offer new revenue streams.
To some extent the rise of exclusion-based investing has impacted demand for companies within certain sectors. In the context of the tobacco sector weakness is, in my view, much more linked to regulatory concerns and the market’s scepticism that companies can continue to generate the prodigious cash flows enjoyed historically.
1 Mark Barnett is the named portfolio manager of:
Invesco Income Fund (UK)
Invesco High Income Fund (UK)
Invesco UK Strategic Income Fund (UK)
The Edinburgh Investment Trust plc
Perpetual Income & Growth Investment Trust
2 Regulatory limit applies to open-ended vehicles. The internal limit is set by Mark and he applies it to all portfolios under his management.
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