Bombed-out supermarket stocks could return to being defensive portfolio holdings and banks may finally end years of lacklustre performance as we head into a new stage in the cycle, according to R&M’s Daniel Hanbury (pictured). 
The FE Alpha Manager, who heads up the R&M UK Equity Income fund, says inflation is likely to carry on rising along with bond yields, which could give a huge boost to two of the most unloved UK sectors.
Generally speaking, he holds a significant weighting towards recovery and asset-backed stocks at the moment due to where he believes we are in the market cycle.
“We’ve realised over the years that there are actually lots of different types of investment opportunities depending on the market environment. It’s a good thing to try and sift through the market to find really great opportunities that are either growth, recovery, quality or asset-backed. We try not to pigeonhole ourselves,” Hanbury explained.
“At the moment we have a significant allocation to recovery and asset-backed stocks because of where we think the market cycle is going.
“A lot of it is linked to inflation and bond yields and the fact they’re starting to rise. We think that environment is much more supportive for our recovery and asset-backed names, typically financials, and more cyclical companies like industrials and technology.
“We quite like the banks and insurance companies at the moment, we like the financial sectors. Food retail is quite interesting at the moment as well.”
Since the financial crash, large- and mid-cap UK bank stocks have struggled to outperform their peers in the FTSE 350 index, having fallen 59.9 per cent since the start of 2008 compared to the index’s loss of 2.96 per cent.
Performance of indices since 2008
Source: FE Analytics
This has been due to a number of factors including more stringent regulatory requirements, hefty fines for any wrongdoing and a general mistrust in banks as businesses since the Lehman Brothers collapse.
This, combined with ultra-loose money policy from central banks keeping interest rates and bond yields low, has significantly bruised the sector over the years.
However, Hanbury believes we are at a point now in the market cycle where banks can begin a path to long-term recovery. R&M UK Equity Income currently holds the likes of Royal Bank of Scotland, Standard Chartered, Barclays, Lloyds and HSBC in its portfolio, with the latter accounting for the third-largest individual weighting at 5 per cent.
Performance of stocks over 10yrs
Source: FE Analytics
“The theory behind this is I want dividends ultimately and, at the moment, HSBC and Lloyds pay the best dividends and have the best ability to pay dividends going forwards, so we own quite a significant chunk of both of these,” Hanbury explained.
“Nonetheless, Barclays, RBS and Standard Chartered are all quite interesting in terms of where we currently are in the cycle.
“With inflation picking up and rising bond yields we think this is a much better environment for them to improve their NIMs [net interest margins], they’re still in cost-cutting mode, we think the regulators will eventually ease off a bit, so that environment will improve for them on a long-term view.
“Return on capital in the industry can improve again. I have a broad spread. I think it’s quite difficult internationally at the moment, we have Asian banks in our index, we have domestic banks. Is Asian growth going to get choked off by rising bond yields in the US? it might, it might not.”
The manager explains that HSBC and Standard Chartered have been significant beneficiaries of rising bond yields in the UK, while the likes of Lloyds pay great dividends. However, he says Lloyds has more exposure to the mortgage market, which is an area he is less comfortable having exposure to.
“We have a good spread, I think broadly banks are a sector that, for the last 10 years, have under-earned. They have still been rumbling along the bottom in terms of where they are in their cycle and we will be exposed to that [turnaround].”
Another unloved sector that Hanbury has exposure to is supermarkets, which have struggled over recent years due to the rise in online shopping and pricing wars between chains.
However, he believes the UK is on the brink of food price inflation which could therefore benefit stocks in this market area.
A well-publicised indicator of this, according to the manager, was the recent price dispute between food manufacturer Unilever and supermarket giant Tesco, when Unilever threatened to raise the prices of goods but Tesco initially refused to transfer these price increases to the end consumer.
“In a way it was a metaphor for a much wider issue which is, post-Brexit and falling sterling, what you’re now going to see is food inflation,” Hanbury continued.
“We’ve had food deflation for several years where there are falling prices in supermarkets. When you’re in London you might not notice it but, as a general rule, there hasn’t been much food inflation. But you’re likely now to see that come through.
“On a pure investment level, we own Sainsbury’s because there’s actually a very high correlation of the performance of food retailers and food inflation. If food price inflation is higher than core inflation, it’s generally going to do very well.”
With the Unilever and Tesco dispute, he argues that there was a political element to it, whereby Tesco publically berated the firm for not taking the rights of consumers into account.
“I think a lot of what hit the media was about saying ‘listen guys, don’t beat us up next year when we start pushing our prices up’ because, when Tesco starts pushing its prices up and their margins start to rebuild, what they don’t want is politicians and newspapers saying they’re profiteering at the expense of the consumer,” Hanbury said.
“So, being cynical, I think there a little bit of posturing here. Ultimately they came to an agreement to possibly a staggered price rise on a number of their good over the next few years.
“But what it will mean is there’s inflation coming through; we’re seeing it in petrol prices and other things that are going to start to feed through and that’s going to hurt people in the pocket.”
Hanbury says food price inflation is good news for food retail companies because, unlike consumer discretionary items, people have to keep buying food as a matter of necessity.
As such, he believes that supermarkets will rotate from being unloved value plays into more defensive areas of the market.
“Food retail used to be considered a defensive industry but of course they’ve been under so much pressure with Aldi, Lidl and the internet. But actually, it will probably go back to being a more defensive area of the market if food price inflation does indeed pick up,” he said.
“One of the investments we have for example is McBride which isn’t food but it’s household, own-label goods. One of the things that will often happen is, when the economy becomes more difficult and you get a squeeze on inflows, people will trade down from brands to own-brand labels.
“As an investor you might think it’s better to own more McBride and a bit less of Reckitt Benckiser for instance, but when you tend to get squeezes on discretionary income people will do trades like that to make savings.”
Since Hanbury has been at the helm of R&M UK Equity Income, it has returned 1.12 per cent compared to its sector average’s loss of 0.17 per cent and its FTSE All Share benchmark’s loss of 3.42 per cent.
Performance of fund vs sector and benchmark under Hanbury
Source: FE Analytics
The £253m fund has a clean ongoing charges figure of 0.94 per cent and currently yields 3.99 per cent.