Moore (pictured) says that many of the defensive stocks that have been favoured by most large equity income funds have been rising in price while their earnings were being downgraded.
Now that a recovery is coming through, such stocks are likely to be exposed and investors need to be wary of expensive areas of the market that have risen on economic sentiment alone, he says. "The P/E on the market has rocketed, it does require earnings growth to come through and that does mean you have to be selective," he said.
"The market has done really well, driven by valuation re-rating and actually that’s normal at the beginning of an economic recovery, because after that it’s all about earnings momentum," he added.
"It means you need to be careful to avoid situations where the share prices have rallied but that hasn’t been followed through in earnings improvement."
"There are some vulnerable parts of the market that are structurally under pressure like AstraZeneca, which sees revenues fall every year until 2017."
AstraZeneca is a top-10 holding in 37 IMA UK Equity Income funds, including FE Alpha Manager Neil Woodford’s Invesco Perpetual High Income fund.
Moore says that it and similar defensive stocks did particularly well in the time when the eurozone problems were the centre of attention, but that this was hiding stock-specific issues in the sectors.
"The reason for big defensive sectors doing so well wasn’t earnings momentum. June was the peak for the defensive sectors (when tapering was first mentioned), and all of the defensive sectors had produced good solid returns, but all while suffering negative earnings revisions," he said.
"And there are also those [sectors] that are maybe quite cyclical that have already performed very strongly and earnings expansion isn’t matching up to expansions," Moore continued.
The manager highlights Marks & Spencer as an example of the latter type of stock, which fell around 3.1 per cent yesterday on the back of a disappointing trading update.
"It’s trading on 15.9 times trailing [P/E] and 14 forward, so it needed good news," he said.
"Tesco is another example: they didn’t produce strong enough numbers overseas to offset weak numbers in the UK."
"There are parts of the market that are vulnerable to poor news, so active fund managers have got their work cut out to identify which stocks they have conviction in and avoid those parts of the market where stocks like Marks and Spencer have rallied on general positive sentiment towards consumer discretionaries."
"This is an opportunity for us, because when the whole market rallies, it creates opportunities to avoid certain areas and redouble some of the holdings which have made good returns in some underperforming areas," he said. "We are excited from here that there are lots of stocks with good news still to come."
Standard Life UK Equity Income Unconstrained has performed exceptionally well since it was taken over by Thomas Moore in January 2009.
Data from FE Analytics shows that the fund has made 54.06 per cent over the past three years while the average IMA UK Equity Income fund has made 36.01 per cent. This is the sixth-best result in the sector over that time.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
Moore explains that as an "unconstrained" manager, he sees his job as trying to do something very different to the market as a whole.
"The whole idea of unconstrained investing is picking individual stocks rather than relying on the market to perform, so investing with conviction but investing very selectively," he said.
"Often, top-down macro managers buy and sell stocks on quite general reasons and unless they are knowledgeable in the bottom-up stock drivers, which are causing problems for Tesco and Marks and Spencer, they can miss the target."
Within income investing, this means looking past headline yield to companies with the potential to grow their dividend over time.
"We are saying with our strategy we are not going for yield: we reject the notion that income investors should settle for yield. We believe you should look at dividend growth levels as well."
"AstraZeneca: the yield is attractive but the share price isn’t moving, so it’s like a corporate bond."
This approach means his fund should maintain and grow the dividend it pays out and will provide a greater total return by picking companies with plenty of growth prospects.
The fund has a strong tendency to outperform in rising markets, although it did lag the last down market of 2011, losing 9.85 per cent against the sector average of 2.9 per cent.
Performance of funds in calendar years
| Name | 2013 | Rank | 2012 | Rank | 2011 | Rank | 2010 | Rank | 2009 | Rank |
|---|---|---|---|---|---|---|---|---|---|---|
| IMA UK Equity Income |
16.58 | N/A |
14.01 | N/A |
-2.9 | N/A | 14.58 | N/A | 22.88 | N/A |
| Stan Life Inv - UK Equity Income Unconstrained |
27.34 | 5 | 23.56 | 8 | -9.85 | 85 | 23.53 | 3 | 42.53 | 3 |
Source: FE Analytics
The fund’s volatility is in part explained by it buying plenty of stocks in the small and mid cap parts of the market, as many of the top-performing funds of the past few years have done – including Chelverton UK Equity Income and Unicorn Income.
Moore says that the pessimists on the UK economy have been proved wrong; however, he does caution that there has yet to be a serious uptick in companies investing their cash, which is good for income investors, but not so for the economy as a whole.
"A lot of my peers were very recently talking about a possible triple-dip and it turns out we didn’t even have a double-dip," he said.
"Maybe it’s where we are in the economic cycle, but companies have surplus cash-flow they maybe don’t know what to do with. You could even say the economic recovery will have truly hit when companies start to invest their cash-flows rather than distribute them."
Standard Life UK Equity Income Unconstrained has ongoing charges of 1.91 per cent and requires a minimum investment of £1,000.
