John McClure of Unicorn talks to Adam Lewis about risk and balance in UK equity income investment.
Q. Last year you described the outlook for British dividends as poor, with Basel III global regulation set to hinder the banking sector. Has this outlook changed at all?
A. The weak balance sheets of the banks remain a problem. My thoughts are that banks are not likely to pay a dividend any time soon.
Q. Are defaults a risk?
A. I don’t perceive this to be particularly high risk. The threat of default in Greece has been resolved, at least for the immediate future. The real problem remains one of how best to generate economic growth. The Piigs [Portugal, Ireland, Italy, Greece and Spain] need growth to stand any chance of running a balanced budget.
Q. Where do you perceive to be the best dividend opportunities?
A. Well-financed and prudently managed companies are likely to increase dividends well ahead of inflation. I do not feel this is sector specific, but I would like the Budget out of the way before I make any further comment. (Q&A continues below)
Q. How would you describe your investment stance – risk on or risk off?
A. Risk on. Investors buying our fund are buying into an equity mandate. It is therefore our responsibility as equity managers to be fully invested, or as near fully invested as fund flows permit.
With the Unicorn Income fund yield for the year ending September 31, 2011, at 5.05%, an investor has at least kept pace with inflation (without factoring in potential for capital growth). It would be difficult for investors to achieve this elsewhere. While there is a capital risk associated with equities, saving rates carry an inflation risk.
Q. The fund’s investment target is to achieve a gross yield at least 10% greater than that of the FTSE All-Share. Are you on track to achieve this?
A. Bang on target. I run the fund under the old IMA UK Equity Income Sector rules and that is to produce 110% of the FTSE All-Share yield each and every year, not on an average three-year rolling basis. This is a matter of principle – investors originally invested in income funds on the basis of 110% of the FTSE All-Share yield a year.
Our peers, in the main, run a barbell approach, so dividends are derived from a small number of stocks. Our research also indicates that large-cap biased UK equity income funds are deriving their income from the same stocks and that the top 10 holdings tend to be the same but weighted slightly differently.
There have been many instances where blue-chip companies have withdrawn their dividends, which impacts large-cap equity income funds running a barbell approach. Hence, these managers lobbied the IMA as a result of the credit crunch impacting dividends to change the income criteria for the sector.
Our fund provides market cap diversification and this gives balance to an equity income portfolio. Every holding must, at the point of investment, produce a yield of at least 110% of the FTSE All-Share. The yield is derived evenly from across the portfolio holdings. If one falls out of bed, this will not prevent us from meeting our yield target.
Q. The fund is competing against an ever widening universe of more global mandates – most recently, global emerging markets income. Why is a Britain-only invested portfolio still a good choice for investors?
A. Because we don’t carry the political risk associated with global emerging markets. Anthony Bolton is an experienced and highly successful fund manager, but even he has found it difficult investing directly in China. Accounting standards are an issue in the emerging economies. Taking a look at these, geographically they seem to be invested in Australia, Hong Kong and Singapore and the yielders are mainly utilities.
There are same-ish “clustering” problems in the UK equity income sector. Investors in these funds should look at their holdings, sector and geographical exposure to avoid duplication.
Emerging market stocks that offer attractive yields do so for a reason – they are likely to be very mature companies. This contradicts the very nature of emerging markets, which are typically perceived as being high growth.
Q. The fund was recently moved out of Principal’s “White List” of equity income funds on to its “Grey List”. Is this a sign that your investment approach is out of favour at present?
A. Not at all. We had a tough September through to December, with mid-to-small caps underperforming, but we have had a strong start to 2012 and this will wash through the numbers.
The White List is a backward-looking quant analysis based on the past five years’ performance. The 2008 numbers mean Principal knew in July, when the fund went on to the White list, that it would be relegated the following December.
This instigated a meeting to ascertain their methodology and rationale behind this comment. Based on quants, an investor would have been better off not investing during the six months July to December. A qualitative overlay would be useful in compiling a list for investors to choose from.
Q. On the Unicorn Outstanding British Companies fund, which you also run, you have said low turnover is key to outperformance. Is this the same on UK Income?
A. Yes, our process is high conviction, buy and hold. It typically has below-average turnover for the sector, although the turnover for UK Income is higher than that of Outstanding British Companies as we have to adjust the holdings to meet yield requirements.
Q. How much of the portfolio is invested in small caps, given that this is an area of expertise for you?
A. Our holdings, with the exception of Renishaw, are all below £1billion market cap and therefore “small” as far as the stockmarket is concerned. Renishaw’s market capitalisation, at point of investment, was about £600m, but it broke through £1billion last December.
Market capitalisation is not a constraint. Historically the fund has continued to hold companies that have grown above and beyond this £16 billion threshold, where the company still meets our rigid investment criteria.
Q. You have won the Lipper Fund Award for best UK Equity Income fund two years in a row. How important is such an accolade?
A. The importance is two consecutive years, and yes, of course I am pleased. The accolade is unbiased and truly independent, from a highly respected industry provider. My more flippant answer: I’ll answer that when I’ve won it five years in a row and achieved world domination.