Darius McDermott: UK Equity Income funds that can ride out Brexit storm

Like the Brexit vote itself, the UK Equity Income sector has seen something of a divergence in recent days. Some funds held up well in the immediate aftermath, while others struggled. What matters now, though, is which ones are well positioned for a nation preparing to leave the European Union.

Over the past five years or so, the stand-out area in the UK equity income space has been small-cap stocks. Our larger listed names have been broadly out of favour from an income perspective, with the big miners, supermarkets and banks among those to reduce or suspend dividend payments.

Following the referendum result, however, we could see a change. We are likely to experience continued uncertainty as questions arise around the time frame in which we exit the EU, what the Bank of England will do about interest rates and, importantly, whether we will retain access to Europe’s single market. Not to mention we need to find a new prime minister. Quite a bit to be getting on with over the next few months.

So there is a lot to be said for having exposure to some larger stocks with a bit more liquidity and a reasonable yield. And I would rather be weighted towards equities in the current low (and probably getting lower) interest rate environment than bonds or cash.

The UK’s larger companies are also better placed to deliver shareholder returns in the current environment. For one thing, a fall in the pound benefits those whose revenues are in US dollars and other global currencies, but whose profits are converted back into sterling. The big oil producers Shell and BP are prominent examples.

Many also declare dividends in US dollars or euros, so total returns could get a nice boost. Additionally, companies such as our big pharmaceuticals, which have a lot of their research and development costs in pounds yet also earn around the world, may be well placed.

The enthusiasm for these stocks was evident to anyone following the FTSE 100 in the days after Brexit was announced. After an anticipated blanket sell-off, investors adopted a more discerning approach. Just one week later, the FTSE 100 was back above where it started the day of the vote (back when markets firmly favoured a Remain scenario). Indeed, by the final day of June it had climbed above where it started 2016. No mean feat given the numerous headwinds it has faced this year.

Logically, then, the UK equity income funds that have done well are by and large focused on the large-cap end of the market and/or are avoiding cyclical stocks such as financials and house builders. These stocks are particularly exposed to the domestic economy and have been some of the hardest hit as concerns over a possible UK recession have arisen.

Elite Rated funds that are well set up to take advantage of these current trends include Evenlode Income, Woodford Equity Income and Threadneedle UK Equity Income.

It is worth mentioning that Evenlode Income, along with two other Elite Rated income funds – Rathbone Income and Schroder Income – has actually fallen out of the Investment Association’s UK Equity Income sector after failing to meet its very stringent yield requirements. However, in my view, Evenlode’s strong performance since the Brexit result is further support of our stance that what matters most is choosing good quality companies with sustainable dividend growth – not simply chasing yield for yield’s sake.

The IA has concluded a review of its sector requirements, for which it is yet to release the results, but in the meantime, we certainly continue to rate and benchmark all three funds against the UK Equity Income sector and not UK All Companies.

Bargain hunting

Returning to small- and mid-cap stocks, there is, of course, another way to play the current scenario. If you continue to favour this area of the market—and I certainly believe there are many good quality companies within this bracket whose fundamental values are not significantly altered by recent events—now could be an excellent time to pick up a few funds on the cheap.

I like both the Elite Rated Standard Life Investments UK Equity Income Unconstrained and Rathbone Income for multi-cap investments that will give you diverse market exposure, including some large-caps to perhaps smooth out returns.

If you really want to focus on the smaller end of town, there is also the Elite Rated Marlborough Multi Cap Income fund, which, despite the name, is heavily weighted to stocks outside the FTSE 100.

Ultimately, though, the most important thing for us to remember over the coming months is that volatility throws up opportunities, both for the long term and the short term. If we can communicate to our clients the merits of buying on the dips, we may well be able to help them achieve decent returns in 2016, despite the challenging conditions.

Darius McDermott is managing director at FundCalibre