“If a nuclear bomb falls on London tomorrow, house prices in Clapham are down – I don’t care what it says in the window of Foxtons. That’s just not the price,” says Aegon Asset Management’s Douglas Scott (pictured), when discussing the low volatility of private equity. “The UK stockmarket, for example, will adjust to that, but private equity and property holdings in Clapham probably won’t adjust overnight.”
The co-manager of the £640.6m Aegon Global Equity Income fund is referring to the rising allocation to unlisted assets within pension funds. This steadily increasing allocation, he says, is coming at the expense of unloved listed UK equities.
“Pension funds used to have a 40% allocation to UK equities, now that is down to 3-4%, and money continues to come out,” Scott explains. “A lot of pension funds are trying to diversify by holding assets like private equity. However, that is just less visible, more leveraged equity.
“You can see that this is happening on a regular basis. People move off to these less visible asset classes because they see it as diversification. But, to me, it just means you can’t see what is around the corner. And because the price hasn’t moved on a daily basis, you think the value is there – but it’s not.”
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That being said, Scott is hardly the UK’s biggest cheerleader. He explains that Aegon used to run a UK equity income fund boasting strong returns, but it was ultimately closed in 2022 because they were unable to sell it.
“The UK stockmarket, I would say, has no unique companies. The last unique one we had, in my eyes, was ARM, but it’s gone,” he argues. “We have good companies, like Experian and AstraZeneca – global companies that compete well in their fields, but they are not unique.”
The manager adds the UK stockmarket is dominated by oil & gas, mining and banking stocks – companies which are far from fashionable in today’s world. And this is even more the case when investing with an income mandate to fulfil.
As such, Aegon Global Equity currently has a 5.7% allocation to the home market. “We have Rio Tinto, which is UK listed but doesn’t operate in the high street of the UK. It is a mining company and very international,” Scott says.
“In terms of UK domestic-facing companies, we have three and one is the smallest holding in the fund, which holds roughly 40 stocks in total. This is London Metric Company, and we also own Taylor Wimpey and Phoenix. If you stripped out where companies are listed and looked at pure UK exposure, it would probably only be a couple of percent.”
US for income
At the opposite end of the spectrum, the fund’s largest regional weighting is to North America at 58.3%. This allocation – while underweight relative to the MSCI ACWI – may be higher than expected for some investors, given the US is not exactly famed for its attractive dividend yields.
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Scott points out that five of the magnificent seven stocks are now paying a dividend, although he caveats this with the fact payouts are “absolutely miniscule” at present. Microsoft is the portfolio’s single biggest holding with an 8.2% weighting as at the end of March 2024.
“The US is not a dividend market. US companies tend to engage more in share buybacks, but they have very, very low pay-out ratios. These low pay-out ratios mean that, even if you do have a bit of a fall in profitability, the dividend is still protected,” the fund manager reasons.
“If you were to ask me the yield on my fund and I tell you it’s just below 3%, you might be underwhelmed. But it’s at a premium to the MSCI – we target a net figure of 130% of MSCI ACWI and we are achieving that, but we are also seeing growth on the other side.
“When you get your dividend, you’ve not taken all the money. You are still invested in that business. If the business is getting a return on equity, you’re still invested in it, they are not giving you all that cash back. They are going to take your money and continue to grow. If they can continue to grow, they can continue to grow that payment stream.”
Trust the process
The fund’s focus on dividend growth has clearly stood the fund in good stead, having found itself in the top quartile for its total returns within the IA Global Equity Income sector over one, three, five and 10 years, as well as over three and six months, according to data from FE Fundinfo.
Scott says compounding is “very, very important” in the fund’s process, so portfolio turnover is therefore “very low”.
“There is very much a buy-and-hold mentality. It is a ‘run your winners’ mentality. We just stick with it,” he explains.
A key trap income investors can fall into, according to the manager, is too much of a focus on the dividend yield itself. “By the time you start to look at a company and think: ‘this is good, the yield has come up a bit’, you wonder whether it will cut its dividend. Then you look again and the yield has gone up even more and you think: ‘oh my goodness it’s going to cut its dividend’. Then, by the time it eventually does cut its dividend, it is too late.”
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Scott believes a key lead indicator for income investors is net debt-to-EBITDA, which he describes as a proxy for how much cash flow a business has relative to its net debt and its return on equity. Essentially, it measures how profitable a business is.
“Applying this to a personal, hypothetical situation: if someone started earning less money and their debts were increasing on a daily basis, everything is heading in the wrong direction. You want to see companies whose profitability is rising and who are able to reduce their debt levels.
“This shows they are generating cash which they can use to pay out a dividend. And that dividend can only compound upwards. That’s the lead indicator. Rising debt within a business, or net debt relative to EBITDA and falling returns is what we look out for.
“Obviously we will never be able to avoid them all. Covid was a time when you couldn’t avoid those cuts – but that was very much a one-off.”
Not-to-magnificent Tesla and sticky inflation
When asked about the prospects for the so-called ‘magnificent seven’ stocks, Scott says Tesla’s days as part of the acronym are numbered.
“In my view, Tesla will not be able to pay a dividend. Tesla will go the wrong way. It has debt, it has cash going out the door and competition is only increasing.”
He points out that, in China alone, there are approximately 100 electric car manufacturers, building cars which are being sold at half the retail price of the average Tesla.
However, the fund manager caveats this with the fact China as a whole could continue to struggle as near-shoring remains in place. And this, he says, is a key reason why he believes inflation will remain stickier than many had hoped at the start of the year.
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“If, for example, you notice that everybody in Edinburgh is wearing a yellow T-shirt, you don’t want to send the order to China and receive them six months later when there’s snow on the ground. So, you bring it closer to home,” Scott argues.
“Also, companies don’t necessarily want to deal with China, because they are concerned about governance issues in relation to its supply chain.
“So, this whole backdrop for me is inflationary. And it will be relatively sticky in the system. China has been exporting deflation to our shores for years and this has broadly ended.
“I think the only area where you will start to see deflation is electric cars.”
Another long-term theme causing stubborn inflation, according to the manager, is the rise of ESG investing.
“If you think that you can shift supply chains and help people to use renewable products that are more expensive, there will be a cost to that. It doesn’t cheapen things and that is not going to go away.”
The importance of dividends
In light of this inflationary backdrop, Scott points out that over the past 80 years, there has been a distinct correlation between the proportion of gains globally deriving from income payouts, relative to inflation in the system.
“Typically, two-thirds [of returns] come from capital and one third come from dividends. And over 80 years, that is normal. There has been a slight aberration more recently, where it was all about capital and not about income.
“Why? Because interest rates were virtually at zero at that point. And if you put a minimum or zero interest rate on something, its capital value increases. And if capital values keep coming up, nobody cares about the income.
“But if you look back to times when we had a more dominant proportion of income, say in the 1970s or the 1940s, they were higher inflationary periods.
“I am not saying we will go back to where inflation was – we think this inflationary boost from Covid was very much a one-off. But I do think inflation is stickier within the system now, for multiple reasons. So I do think, going forwards, that dividends will become much more important.”
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