Written by Chris McVey, Senior Fund Manager on the Quoted team at Octopus Investments
Five years ago, I became a father, and launched a new fund. I’ve found that managing a young fund, in some ways, has mirrored the experience of raising my daughter, as they’ve both required my care and attention in their own ways.
As she has turned five, my daughter has reached the various milestones as expected, much to our relief. As the fund has reached the same age, again it has achieved much of what we expected, although has seen a few more challenges given the market conditions of the last two years. As we look forward however the prospects are hugely exciting – for both.
A multi cap approach offers investors diversification, and growth potential
When developing the fund strategy, we looked closely at some of the challenges within much of the IA UK Equity Income sector.
We identified three key risks potentially impacting a sizeable proportion of the sector; significant holding concentration across many ‘traditional’ equity income funds, low dividend covers amongst holdings and low potential growth for these businesses.
So, we took a multi-cap approach, with a bias towards faster growth, progressive, small and mid-cap companies. This mitigated some of these concerns and offered investors true diversification when considering UK equity income options.
Our strategy has now been well tested over the fund’s first five years through some very tough market conditions, with the recent rising interest rate environment particularly impacting valuations within our core area of focus, UK growth companies.
Despite these challenges, with the narrative around interest rates very much now looking toward future cuts, we believe now is the time to be re-evaluating asset allocations towards a more diversifed approach to UK equity income generation.
Diversification: Mitigating concentration risk, targeting more attractive returns
As we look back on 2023, many of the issues we identified at the outset of the year remained as it came to a close. Just ten stocks are forecast to pay nearly 55% of all UK dividends. In fact, the top 20 are expected to generate some 73% of all cash dividends paid out to UK investors.
The most popular stock is Royal Dutch Shell, which features as a top ten holding in 64% of funds within the IA UK Equity Income sector.
A significant proportion of equity income funds also hold material weightings within many of the other traditional dividend paying sectors such as banks, pharma, and mining.
Holding multiple income funds to provide diversification therefore continues to fail to deliver the desired effect. The chances are you’ll remain over-reliant on a few large companies, and if these companies don’t perform, neither do the funds you hold.
We suggest that it is better to look across the entire UK equity market, with minimal, if any, exposure to the most popular stocks across the IA UK Equity Income sector.
This will help your clients to reduce concentration risk, while benefitting from the merits offered by faster growth, progressive, small and mid-cap companies, and still targeting a healthy yield.
Small and mid-cap stocks – dividend cover and income growth potential
Again, as at the outset of the fund launch, dividend cover, and potential growth, across much of the UK equity income sector remains a concern.
Whilst cover has generally improved across the market since Covid, the FTSE 100 still only operates with just over what we see as the sufficient comfort level of 2x cover, lower than any other index. Looking to the rest of the year, dividend cover is also expected to increase for every index except the FTSE 100, which is expected to decline.
By focussing on this relatively narrow pool of companies, these investors also miss out on some of the more dynamic, and fast-growing, income-generating stocks outside of the FTSE 100. These smaller and mid-sized companies can offer faster-than-market growth potential, which will in turn underpin a progressive dividend.
These companies can offer investors that perfect blend of a steady revenue and profit growth trajectory, and increasingly attractive dividends.
To optimise returns, we use what we describe as a ‘core and satellite’ approach to portfolio construction. The core is companies that we believe can grow earnings and dividends ahead of the market. We look for robust finances, superior prospects for profit growth, quality management, appropriate balance sheets and good earnings visibility.
The satellite positions are designed with two key attributes in mind – income or growth.
Income satellites are those companies potentially delivering superior, sustainable dividends, which boosts the overall yield of the portfolio, whilst the growth satellites are expected to demonstrate exceptional growth opportunities, albeit with lower near-term dividend expectations.
The Double Discount – are your clients read for a rebound in UK growth equities?
Over recent years, the UK equity market has fallen out of favour with investors, helping to push many valuations to levels not seen since the financial crisis. UK growth equities are trading at an even greater discount. So why now and what is the potential rebound?
From an operational perspective, solid trading continues to be reported across much of the market and our portfolio. The UK economy also continues to see its economic performance upgraded.
Yet with the rising interest rate environment, and largely unfounded negative sentiment towards the UK, and UK growth stocks in particular, valuations are now at a material discount to historic levels, and to peer markets.
UK equities are now trading close to a 40% discount to the rest of the developed world, and the FTSE 100 is at a material discount to long term average multiples. Further to this, UK small and mid-cap companies are at a 20% valuation discount to their larger FTSE 100 peers.
These valuation levels are once-in-a-cycle and present a significant ‘double-discount’ opportunity. This offers scope for material upside returns from current levels for investors prepared to revisit the UK, and in particular for those looking more widely than the FTSE 100, as we do.
Clearly the UK market is astoundingly cheap and, as we have noted, even more so for smaller growth companies. In previous cycles, when growth company equity valuations have reached similar or greater discounts to current levels, the subsequent two-year sector recovery was material, and outstripped returns generated by larger-cap peers.
With the macro-outlook remaining generally steady, and the interest rate pivot now in our sights, we suggest now is the time to be re-evaluating asset allocations towards a more diversifed approach to UK equity income generation.
