The FTSE All Share is now pricing in dividend cuts that are two-thirds deeper than those seen in the financial crisis, according to Schroders’ Sue Noffke, who says the attitude of global fund managers over the past three years can be summed up as “I’m a UK equity investor – get me out of here!”
In a recent article on FE Trustnet, Laura Foll, co-manager of the Lowland Investment Company, pointed out the Bank of America Merrill Lynch (BofAML) Fund Manager Survey had had to adjust the scale on its chart to show just how out of favour the UK is among international investors.
This has led to $40bn of money being pulled out of the UK market over the past three years.
While a greater number of sellers than buyers will have an obvious detrimental impact on prices, Noffke (pictured), manager of the Schroder Income Growth trust, said it is worth comparing current valuations to history to show just how cheap the UK is.
“The UK is on a 30 per cent valuation discount globally – that is a 30-year low,” she explained.
“We are lower than in the midst of the global financial crisis, we are lower than in the tech boom and bust – you have to go back to the early 1990s recession which was bloody, but we did recover from that.
“Looking at valuations from an income perspective, you are getting nearly double dividend yields in UK equities compared with global equities, so 1.8x the level of income you can get internationally. And again we have only been higher back in the tech boom.”
It can be difficult to put such figures into perspective and even comparing them with the FTSE’s valuation during previous crises is of limited use due to the way the world has changed since then.
Instead, Noffke said it would be more instructive to look at what it would take for the yield to return to its 30-year average of 3.5 per cent – which, the manager pointed out, would still be an attractive figure relative to inflation.
“On a 12-month forward basis at the end of 2018, UK equities were yielding 4.8 per cent,” she continued.
“It would take either a cut of 25 per cent of dividend income to get you back to the 30-year average of 3.5 per cent, or a rise in the UK equity market of over 35 per cent. It may be a combination of the two.
“Just to put it in perspective, the cuts that we saw in dividend income for UK equities in the financial crisis were a cumulative 15 per cent. And so we are discounting a situation much worse than that.”
Despite the fact that Brexit is dominating the headlines at the moment, Noffke said it is worth remembering it is not a global problem, as the financial crisis was, but a local one with the largest potential impact confined to domestically focused businesses. Yet the FTSE is an international stock market with almost three quarters of sales derived from outside the UK. This makes the low valuations on some of the major multinationals irrational.
However, she said it is the domestic area of the UK equity market that has seen the biggest slump since the referendum in 2016 and so this is the area she has added to over the past year.
“We have a bottom-up fundamental process of evaluating opportunities,” the manager continued. “And we did a lot of sitting on our hands and looking at where those opportunities might arise, but really towards the end of 2017 and 2018 we felt that the valuation opportunity particularly in domestics was so compelling we couldn’t wait any longer.
“We started to add to our domestic, UK-exposed names in the portfolio and also bought some new names.”
One of the businesses she has added to Schroder Income Growth is supermarket giant Tesco.
“Tesco is well through a turnaround under new management after problems with accounting and fraud and also alienating its customers with too high prices and poor customer service,” she added.
“What we have seen is management gain traction and the shares, certainly in share price terms, are not rewarding those actions with performance in the market. And we took advantage of that and bought it at the end of 2017 and have added to it since.
“We can see balance sheet repair, decent levels of cash generation and a return to the dividend list, with good levels of dividend growth into the future, so that has been a new and I think quite low-risk UK equity opportunity to put into the portfolio.”
So how long after a final decision is made on Brexit will UK investors have to wait to see a reversal in outflows? Noffke is optimistic this trend will begin sooner rather than later.
Alongside Schroder Income Growth, the manager also runs large amounts of institutional equity money in the UK, where she said there has been “radio silence” from international investors for the past three years.
“We came very close in May 2016 to signing with a sovereign wealth fund and we got to negotiating fees but they never signed on the dotted line,” she added.
“They called us up at the beginning of 2019 and we had a conversation with them just last week, but that is the first serious interest we have seen from a large-scale, longer-term player. That gives me some comfort.
“There are enough people out there where this is screaming [value] – even if they haven’t moved yet, they are getting ready to have a proper look. But that is the first time for a very long time.”
Data from FE Analytics shows Schroder Income Growth has made 92.5 per cent since Noffke took charge in July 2011, compared with gains of 83.85 per cent from its IT UK Equity Income sector and 66.9 per cent from its FTSE All Share benchmark.
Performance of trust vs sector and index under manager tenure
Source: FE Analytics
The trust is trading at a discount to net asset value (NAV) of 6.2 per cent compared with 6.96 and 7.98 per cent from its one- and three-year averages. It is not currently geared.
It is yielding 4.21 per cent and has ongoing charges of 0.93 per cent.