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Viewpoint: UK equities present income opportunities
Downing’s James Lynch presents the argument for UK equity income sector and explains why well-diversified, high conviction portfolios can provide investors with premium yield and long-term capital growth.
Q4 2016 has so far been a challenging period for most markets. Global economies remain in a state of flux as investors wait to understand the impact of the new US president elect’s policies, and how events such as Brexit will affect global markets. The Fed’s inaction regarding interest rates has allowed some breathing space, although UK inflation has exceeded targets and forecasts have been revised which has added to domestic economic uncertainty. In Emerging Markets, investor sentiment has generally recovered, although whether this will continue following a US rate rise is yet to be seen. The global landscape is further complicated by Syria’s civil war, which has been exacerbated by extremist group IS’ opportunistic ‘invasion’.
This less-than-perfect backdrop for markets has led to increasing realisation that income strategies are appropriate both for wealth creation and income provision to support rising living costs. We believe income investors represent a growing segment of the UK population given the ascent of defined contribution pension plans in place of defined benefit schemes, and the number of people reaching retirement age increasing. This trend has been further reinforced by the pensions freedoms act which allows retirees to select alternatives to traditional annuities. However, generating a high and sustainable income stream within a low growth, low interest rate environment, continues to be a quandary for investors. Fixed income is no longer the obvious go-to place for quality income, and prime commercial property valuations appear increasingly overvalued. As a result, we believe many investors are turning to equity income for yield and when looking for yield the UK market can present a compelling opportunity.
This has led to significant inflows into UK equity income funds in recent years, resulting in a high concentration of investment in the same companies: research has shown that 23% of all assets in the sector are invested in the same ten stocks*. One reason for this is that some of the larger funds are simply unable to take a meaningful position in quality companies further down the market cap scale due to size. However, diversification across the smaller and mid-cap markets has considerable merit and this is where boutique investment managers and smaller funds are able to differentiate and provide investors with access to attractive returns.
A number of UK equity income funds have adopted a multi cap approach and a skew towards small and mid-cap companies. Smaller companies are an untapped income resource for a number of reasons, primarily due to the largest funds being unable to invest in this space. Nonetheless, there are numerous reasons why small-caps can present an attractive alternative, or even a complementary holding, to large-cap equity income portfolios.
Smaller companies have generated greater returns than larger ones over the last 10 years and have done so with lower levels of volatility**, providing investors access to attractive risk adjusted returns. These businesses are often under-researched and operate in an inefficient market, which present opportunities for diligent investors to capitalise on. They tend to be nimbler and more flexible than larger companies with faster growth potential. Board members’ interests tend to have greater alignment with their investors and many of these businesses are highly cash generative which allows them to pay attractive dividends that are able to grow over time. Small company investing is a specialist area and requires a greater deal of due diligence than may be required in the large-cap arena. It is also important that managers distinguish between new and growing start-ups as opposed to the small companies who fulfil a niche and have free cash flow at their disposal to reward shareholders.
Other advantages of smaller companies lie in their ability to provide portfolio diversification and an ability to deliver better return outcomes, as well as helping smooth overall portfolio volatility. Ultimately, we believe (and there seems to be a growing consensus) that it is pragmatic to diversify income streams across the market cap spectrum. Doing so within a high conviction portfolio should provide investors with a strong opportunity for a premium yield and long term capital growth.
Fund Manager, Downing
*Source: Analysis: The mounting threat to equity income trusts' dividends, Investment Trust Intelligence Investor Edition, November 2016
**Source: Numis Smaller Companies Index 2016 Annual Review
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