The death of the UK equity income sector has been greatly exaggerated, according to James Sullivan, head of multi-asset and partnerships at Tyndall Investment Management.
After suffering from years of weak performance followed by a devastating blow caused by the coronavirus pandemic, the IA UK Equity Income sector has had a revival in performance in the last several months.
But aside from a recent uptick in performance, there is another reason why investors should be reconsidering their exposure to the asset class.
Sullivan said: “Coming off a low base and with UK equity income being priced at a significant discount to global equities, now is probably the time to be brave and start collecting exposures to UK equity income to complement those more growth biases that many people find to become embedded within their portfolio.”
Indeed, investors who have benefitted from the last few years of great performance from growth-heavy portfolios may be more exposed to growth than they realise as the size of these position swell relative to weaker performers.
Over the last 10 years, there has been a divergence in performance between the average IA UK Equity Income fund and growth assets, as measured by the MSCI World Growth index.
MSCI World Growth versus IA UK Equity Income over 10yrs
Source: FE Analytics
“I think facing in only one direction obviously leaves the danger of a very binary outcome,” Sullivan said.
This could mean that if growth assets were to become out of favour due to inflation or a reversion to the mean, investors overly weighted towards growth will be left facing the brunt of the damage.
Sullivan continued: “I think the diversification within equities is grossly overlooked at times and if we are in a period of re inflation - whether it's transitory or prolonged - it doesn't really matter.”
He argued that UK equity income is well placed for a reinflationary environment – if it did occur.
“Having taken the pain throughout 2020 with a raft of dividend suspensions, perversely companies that have reset their dividends now stand a good chance of being able to grow dividends in line with or above inflation,” he explained.
“On forward earnings, pay-out ratios don’t look stretched, offering scope to dial up dividends as the macro environment develops.
“Paired with the ability to re rate from a low base, such companies will be much in demand during an inflationary backdrop.”
As inflation fears have grown over the last six months, the IA UK Equity Income sector is up 26.99 per cent compared to just 5.23 per cent from the MSCI World Growth index.
Performance of IA UK Equity Income v MSCI World Growth over 6 months
Source: FE Analytics
As investors continue down the ‘reinflation’ path, unsure as to whether it is truly transitory or something more sinister, Sullivan believes diversification can be beneficial.
“UK equity income, once the darling of the investment community, has been banished to the archives for the past decade or so. QE and suppression of bond yields has catalysed a move towards growth investing, a shift away from the more cyclically-sensitive, at times income-orientated, areas of the market,” he said.
“Yet during the past quarter or so, there are signs that the death of value investing has been exaggerated. Investors have sought solace in defensive and cyclical areas of the market as the economic data shows signs of life and the avalanche of loose money finds leaks out of financial assets and into the real economy.”
Whilst he admits there is no denying that technology companies carry great momentum and will likely “remain the leading lights of innovation”, he argued that UK dividend energy giant BP ought to be reconsidered.
In recent months, BP has benefitted from the rotation towards value with its share price is up 60 per cent over six months versus the FTSE All Share of 22 per cent.
Performance of BP versus FTSE All Share over 6 months
Source: FE Analytics
Sullivan explained: “Investing in ‘greening’ companies carries the optionality of making a tangible contribution towards a more sustainable future whilst benefitting from a material re-rating of the company, and that can only be achieved in a meaningful fashion by giving consideration to the UK equity income sector.”
He highlighted how BP has committed to cut its oil production and aims to reach 50 gigawatts of renewable energy by 2030 - more than the total of the renewable capacity in the UK at present.
As part of its drive towards renewable energy, it has recently been selected as preferred bidders for two significant sites in the Irish Sea with the potential generating capacity of 3 gigawatts.
“A good business moves to ‘where the puck is going’ and BP is displaying such traits,” Sullivan said, but despite this, BP is company that is unlikely to be found in many ‘growth’ portfolios or indeed given any credence by the ESG community.
However, not all UK equity income exposure will give investors the same benefits of diversification. Alex Odd, former M&G equity income manager turned founder and Tyndall Investment Management chief executive, said the sector has become “mind-bendingly homogenous”.
“What used to be an exercise in trying to generate returns for clients has become increasingly a marginalised process with ever greater emphasis on risk mitigation, indexation and all the portfolios were getting increasingly homogenised,” he said.
“It's been this long-standing argument that UK equity income doesn't provide much income and it doesn't generate any returns. I think that we've shown over the course of the last sort of 12 to 15 months that it doesn't have to be the case.”
Odd pointed to the performance of the VT Tyndall Real Income fund, which has delivered top-quartile performance since Simon Murphy took over in February 2020.
Over the last year, it has returned 57.51 per cent versus 31.42 per cent from the average IA UK Equity Income fund.
Performance of VT Tyndall Real Income versus sector over 1yr
Source: FE Analytics
“To have a fund that is effectively doubled the return of the sector over the last year speaks very powerfully to what we're trying to achieve,” Odd continued.
“What investors in our funds get out of it is a differentiated return profile.”
Conversely, in his view, managers that are index and benchmark aware and insist on buying high yielding UK stocks probably won’t generate good returns.
“We're not going to turn around and say ‘well our risk-adjusted returns are absolutely fantastic’ -we're trying to genuinely generate proper alpha for people,” Odd said.
“Active share is an important element of that, and then that feeds through to performance which is ultimately proof in the pudding.”