The areas of the UK stock market that lend themselves to tough market conditions aren’t providing investors with a margin of safety because of valuation risk, according to Rathbones’ Carl Stick (pictured). 
The manager, who heads up the five crown-rated Rathbone Income fund, says now is a particularly difficult time in markets and warns that 2017 is likely to present investors with several challenges.
As such, he is seeking opportunities in what he refers to as “high-quality compounders” and “defensive cash cows” despite their high valuations.
2016 has been a turbulent year for UK investors, with the first six weeks reflecting negative market sentiment caused by China’s growth slowdown, low commodity prices and geopolitical uncertainty.
Since then, the FTSE 100 index has performed strongly, demonstrating surprisingly sanguine behaviour from investors in the run-up to the EU referendum and delivering an even stronger performance after the result following a slump in sterling.
Performance of index in 2016
Source: FE Analytics
Stick says the buoyancy of the UK market could be cause for concern and warns that this, combined with low growth levels and uncertainty in the run-up to Article 50 being triggered, makes the current environment challenging in terms of finding opportunities.
He says while domestic-facing stocks are attractively valued, they carry a number of macro-related risks. On the other hand, global-facing, more defensive stocks are mostly sound businesses but carry valuation risk.
“What we’re dealing right now is that lots of great businesses – businesses we own, that people are buying and we’re owning them because they’re great businesses – don’t necessarily give us that margin of safety,” he warned.
“The deal that we are doing is saying we are owning these businesses but we recognise that the price we’re owning them at does not give us a margin of safety. I’m not alone in this. A lot of the businesses I’m talking about, other people own.”
In terms of “high-quality compounders” – or stocks that consistently generate high returns on a growing capital base – Stick says business risk is generally low but financial risk could increase if the global economy comes under greater strain.
While price risk in this area of the market is high, he says there are also good reasons that valuations could remain high over the longer term.
“There is this central tension between valuations and interest rates and there are tensions between what do we do tactically right now and what do we do strategically over a long period of time,” he explained.
“A lot of the discussion around this goes into very big themes, such as demographics. We are getting older as a population, the workforce is shrinking, and many of these arguments are leading to this discussion that interest rates will stay lower for longer.
“I’m not talking about the next three months; I’m talking about decades. If interest rates were to stay lower for longer, you want to be owning these stocks.”
Examples of holdings that the manager owns in this part of the market include Unilever, Reckitt Benckiser and German firm AB InBev.
While he admits that there is “practically no margin of safety” in the prices of these stocks, Stick believes they are going to remain strong performers over the next five to 10 years and their price is therefore justified.
Performance of UK stocks over 5yrs
Source: FE Analytics
Other types of compounders he owns are those that are more growth-orientated. Again, while he owns them at a high rating, he says the price is justified by their high growth prospects.
In this area of the market, he holds stocks such as veterinary product manufacturer Dechra and Dublin-based firm UDG Healthcare.
Given their prices and their low yields though, the manager is sitting on them rather than increasing his exposure.
The final tranche when it comes to high-quality compounders that Stick owns is what he calls “roll-up businesses” such as Bunzl, Micro Focus and DCC, which sell products consumers need while also buying new businesses to increase their existing entity.
“Again, the principle is the same. We like these businesses, they are the core of the portfolio, but tactically there’s the price risk. Long term, if rates stay lower for longer, there’s a very good reason to be owning them but we must not be complacent about our positioning,” he continued.
“It’s not that surprising that we have dealt with this pricing issue on many occasions over the last two or three years and it’s not going away, so we need to keep considering that.”
Another type of investment the manager holds - which has divided opinion among investors over the last year or so – is ‘bond proxies’ or dividend-paying stalwart stocks often trading on high valuations.
In this part of the portfolio, he holds the likes of British American Tobacco, AstraZeneca and BAE Systems. He also holds overseas stocks such as US tobacco firm Altria, telecoms provider Verizon and US utilities stock WEC Energy Group.
In total, these “defensive cash cows” account for 19.8 per cent of the Rathbone Income fund.
“If I’m feeling a bit more bearish – and I am – it’s maybe a case of simply going back into a more defensive mode,” Stick said.
“Now, we may be wrong. If interest rates go up because economies are growing, then bond proxies may not be the best place to be. But, as I say, I am taking a more defensive tact.
“So we want businesses with low business risk, some financial risk but not too much, but also relatively low price risk. We recognise they’re bond proxies.”
The £1.4bn fund also holds 5.3 per cent in cash, although the manager admits he would like this weighting to be higher given his stance on the economy over the medium term.
The reason this weighting is lower than he would ideally like is because he has been putting new money in defensive, more expensive names to protect as much capital as possible while also providing consistent and growing income pay-outs to investors.
“Dividends are the key. The best thing we can do is give our investors a pay rise each year. The yield on the fund is 3.7 per cent, which is pretty good in a low interest rates environment,” Stick said.
“But, if I can keep on growing that, that’s perfect. If I rely on growing my distribution, I expect the unit price to look after itself. What we do versus the market over the short term is out of my hands. If I can grow the distribution year-on-year, our total return looks after itself.
“It’s very important we’re mindful of downside risk and winning without losing, giving out a pay rise every year, and that in my mind is my job well done.”
Since Stick launched the fund at the turn of the millennium, it has outperformed its sector average and benchmark more than three times over with a total return of 317.42 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
If an investor has put £1,000 into the fund at launch, they would have received £946.93 in income.
Rathbone Income has a clean ongoing charges figure of 0.8 per cent.