What would you say sets this income fund apart from the many others that are on the market?
I would say our dividend record is really the fund’s USP. We have two objectives; one is based around total return – we want to outperform the FTSE All-Share and we measure that over rolling five year periods. We’ve got a good track record there.
And secondly, we’ve a lot of experience in our team. Carl [Stick] started running this fund in 2000. Kate [Pettem] is a senior analyst on the fund and she has over 35 years’ experience, and I’ve been here since 2005. Keval [Thakrar] also joined us in 2021 as an analyst in the fund. So we’ve got a lot of experience and the team has been together for a long time going through a few market cycles.
The fund’s other objective is its dividend growth objective, the fund’s USP as I mentioned. We’ve grown the dividend in 28 of the last 30 years – I think that’s a record. I’m not sure any other open-ended income fund has got a dividend growth record like that.
See also: Should income seeking investors consider UK small caps?
How would you describe your investment style?
Some of our clients hold us for total return, some hold us for income and the dividend growth. I would say we have the two bases covered. We have quite a flexible investment style, we don’t really want to be pigeonholed as value managers or quality growth managers.
We are valuation conscious and move the portfolio positioning around depending on market conditions and where we’re seeing opportunities. From 2000 up to the start of the financial crisis, the fund was positioned, especially in the early part following the .com bust, in small-to-mid-cap value stocks and did very well.
The next period from the financial crisis up to the start of Covid, the fund did well from holding more large-cap, defensive growth stocks, the Unilevers and Diageos etc.
And then, more recently, we’ve done fairly well by being a bit more tilted towards value since Covid.
So we have that flexibility, we’re not static and will only do well when value does well or when growth is doing well. We try and benefit in all market conditions.
Where are you finding the best opportunities right now?
To give some context, more recently when we became much more positive on value and cyclicality in mid-2020. We had done well by holding those defensive growth stocks when bond yields were falling over that decade – that positioning really helped us out in the very early stages of the pandemic.
But then we felt that a huge valuation gap had opened up between the pandemic winners and losers – the tech, consumer staples and utilities on one side and then nobody wanted to own banks, housebuilders and oils.
We made probably one of the biggest style shifts in the fund’s history based on that valuation gap between those two groups.
Also, we became quite concerned about the certainty in the market that inflation was dead – if you remember the sheer scale of fiscal and monetary stimulus that was put into the system at that time, but the market was convinced that the only outcome here was going to be deflation.
We weren’t quite so sure – we certainly weren’t predicting double-digit inflation, we were not that clever – but we did think there was potentially another outcome here and that was a bit of inflation coming back.
We were worried about what was going to happen to the valuations and ratings of those defensive growth businesses in that scenario if a bit of inflation came back so we made this huge shift.
We sold a lot of Reckitt, Unilever, Relx, Bunzl and Glaxo around that time. We were buying Natwest, or Bank of Scotland as it was still back then, housebuilders and some mining stocks.
That positioning served us pretty well over the past three years or so, we’ve modestly outperformed the benchmark and our peer group average, but we’ve certainly done a lot better than if we had stayed in those quality compound of stocks. We would have underperformed so we’re reasonably pleased we made that change.
Today, I would say we’re now moving the fund back to being a bit more neutrally positioned. We are no longer heavily overweight value and cyclicality, and moving more towards defensive growth stocks. We prefer gentle nudges on the tiller, rather than screeching handbrake turns, and that’s how we manage the fund.
Have any other new names been added to the portfolio?
An interesting name that we bought last year was Games Workshop. The business that makes wargaming figurines and Warhammer is one of their main brands. It’s a really fascinating business and quite international with only around 20% UK revenues. They sell a lot in the US, Australia and Canada.
It’s a niche business, very cash generative, high returns, and pays a lot of dividends. We also felt their licencing potential hadn’t really been fully exploited. There’s a lot of fan-created content around fantasy worlds – they hadn’t really done a lot in that area but then we were very pleased to hear towards the end of the year a deal with Amazon Studios announced to bring the Warhammer franchise to either the small or the big screen.
They have confirmed they have Henry Cavill from Superman fame lined up to be part of this, so that’s incredibly exciting.
I will name one more because it’s a business that I think is fantastic – Legal & General.
We really don’t appreciate it [as a business] in the UK, but it is one of our largest holdings on the fund. It is really well managed business, there are lots of synergies between its different divisions. It has been a real beneficiary of rising bond yields over the last year or so, both in terms of how it improves its capital position, but more importantly, it increases demand for its pension risk transfer business.
There’s a lot of defined benefit pension schemes sitting out there on corporate balance sheets. As bond yields rise, these schemes become better funded, and then they can be offloaded to an insurance company.
This is the end point that a lot of corporates want to get to, they don’t really want these schemes closed to new members and they don’t want them sitting on their balance sheet anymore so they transfer them to a business like Legal and General.
Demand for that part of the business, which is most of it, should be extremely strong in 2023/2024. It is just a great opportunity within a relatively unloved market.
In one of your recent commentaries you mentioned you were bullish on banks. Can you explain?
That’s been an interesting place to be over the last couple of months. Initially, we became much more positive on banks in mid-2020 and I mentioned that we bought Natwest because it was very, very cheap, was trading at less than half book value and its capital position was strong. It had spent the previous decade atoning for the sins of the financial crisis, capital positions were three or four times better than they were in 2007/2008. So that was the initial investment case.
As time progressed, and we had inflation and rising interest rates in the UK, the investment case became more of a profit upgrade story, a dividend growth story, than simply a value re-rating.
That played out nicely in 2021/2022, even heading into this year. But I would say that some of the easiest wins were done then in terms of re-rating. We then had Silicon Valley Bank and Credit Suisse and, understandably, these shook confidence in the sector.
We do think that UK banks are in a really different place to US regional banks, particularly Silicon Valley Bank, or a big Swiss bank. But with the experience of our team, we know from history that contagion risks are really real in the banking sector. It’s quite an opaque sector. We did take action, we exited from a position of Barclays in March, so I’d say we’re relatively neutrally positioned on banks at the moment.
We still think there’s still lots of positives, they’re really well capitalised and some of the accounting regulation changes have been really positive in terms of recognising potential loan losses much earlier than, for instance, in the financial crisis, they’re still going to benefit from the lagged effects of rising interest rates, and they should still pay attractive and rising dividend. But maybe the re-rating story has taken a bit of a knock because of the lack of confidence in the sector over the past couple of months.
What have your key engagement conversations been around recently?
You’re not going to be surprised to hear me say that we engage a lot on dividends. We spend quite a lot of time talking to company managements and boards trying to get across even though we manage an equity income fund and we’re obviously very focused on dividends, we are first and foremost long-term investors.
And we want boards to do the right thing for the long-term future of the business, and for long-term shareholder value creation, even if that means scrapping or cutting a dividend, which sometimes comes as a bit of a surprise to them.
We’re not all out yield at the expense of the business by any means. We want businesses to allocate capital sensibly even if that means getting rid of the dividend.
We also engage on two other things more generally; strategy and ESG. We’re very fortunate that we have an in-house stewardship team, they help us a lot with analysis, voting advice and as the specialists in the area, they will often lead engagement if it’s required on things like executive pay, carbon emissions, diversity, and representation on boards etc.
Sometimes, not often, but sometimes we proactively engaged with companies giving them our views or write letters. We wrote a letter at the end of last year to one of our holdings telling it that we thought its balance sheet was a bit over geared and instead of doing a buyback, it should be trying to reduce debt. The company gave us a very polite response to that. It’s an important part of the job.
You’ve mentioned that the team is very experienced and has seen lots of different market conditions. How does this current situation compare with other challenging periods in your career?
There’s always challenges, there’s always uncertainties, but I think it’s important to remember these are often the building blocks for future outperformance.
One of the big challenges we see at the moment is the continued flow of funds away from the UK market. It’s very well documented investors have been shunning the UK equity market in favour of fixed income and global equities over recent years.
The UK market has been shrinking and we have seen fewer IPOs with preference for overseas listings because you can get a higher rating in some other markets. That’s led to a de-rating of the UK market and it now trades on a 30% discount to a global ex UK index.
We can come up with lots of narratives around why that should be the case – Brexit and politics and too few tech companies – but just looking at the value on offer in the UK at the moment versus other markets makes us pretty excited about the potential returns from the UK market going forward.
Finding a catalyst for that is always the tricky bit. But I think corporates are sensing a window of opportunity in the UK, they can buy businesses here cheaper than they can elsewhere, which is just a reverse of the reason that some UK companies want to go and list elsewhere.
We’re also seeing greater political stability in the UK, and we’ve got a more robust economy than I think many of us envisioned six months ago. Relative to other equity markets, we think it’s a really attractive opportunity at the moment.
