Join our community of smart investors

Flying the flag

John Baron continues to believe the UK market looks attractive - particularly smaller companies paying good dividends
May 8, 2015

Regular readers will know that I have recently been extolling the virtues of the UK equity market and building exposure. This is not the consensus view, which instead seems to be focused on a number of negatives, including the general election. This has left the market looking good value relative to the rest of the world, while offering a decent yield.

Meanwhile, within the UK market, smaller companies have recently underperformed. With the economic recovery now well established, I suggest this is a good time to increase exposure to good-yielding smaller company investment trusts while they are standing at attractive discounts. Sentiment will catch up with fundamentals.

 

The UK market

British cynicism remains a source of strength at the best of times, but sometimes we can overdo it. Despite a host of positive economic indicators, including an economy which is growing faster than most of our peers, low and falling unemployment, and business confidence building, the market appears concerned about uncertainties.

Top of the list has been the general election. To a certain extent, this is understandable. The possibility of a Conservative-led coalition ushering in an EU referendum, or some type of informal Labour/SNP coalition being less friendly for business, has unsettled some. This is despite evidence to suggest elections in themselves have little or no impact on the longer-term direction of the market.

The market’s relatively high exposure both to commodities – around twice the level of most other developed equity markets – and eurozone economies, has also weighed on sentiment at a time when economic growth rates in general are in question. As a result of all this uncertainty, investors have been moving money out of the equity market.

The question for investors is the extent to which these concerns are priced in to the market. History is a guide. Recent figures from Datastream suggest the UK market may be at its cheapest for nearly 30 years when compared to global markets in general – the latest recent down-leg cementing the statistic. Furthermore, a prospective yield of nearly 3.5 per cent for the FTSE All-Share compares favourably with other markets.

As such, I suggest prices largely reflect the uncertainty. Interestingly, the gilt market seems less concerned about the result, with yields having fallen in the year to date. Today’s concerns about politics, commodity prices and eurozone exposure could easily become tomorrow’s positives – especially as the UK’s economic fundamentals are better than most, and improving.

In addition, the evidence suggests trying to time the markets rarely works for investors – I leave such decisions to wiser investors. But factoring in politics reduces further the chances of getting it right. Investors should instead focus on the disparity between sentiment and fundamentals. The world and its markets will move on.

For example, the same doomsters who warned of the dire consequences of the UK not joining the euro, or forecast a decrease in inward investment following the party’s adoption of the referendum policy, should not now be listened to about the dangers of an EU referendum. Whatever the result, trade will continue – it is in the EU’s interests given the size of its trade surplus with the UK.

So, as far as the UK market is concerned, do not sell in May! Take comfort from the market’s de-rating and look to buy into the uncertainty. If there are post-election coalition talks, then invest on any bad days immediately afterwards. And what better to buy than out-of-favour smaller company investment trusts following the sector’s recent underperformance and its exposure to the domestic economy – especially those offering decent yields.

 

Acorn Income Fund

Space in last month’s column did not allow me to explain why I introduced Acorn Income Fund (AIF) to both the Growth and Income portfolios during March. AIF is the ordinary share of a split-capital investment trust, and its objective is to provide a high and growing level of income together with capital growth.

Around three-quarters of the portfolio is invested in smaller company equities, with the balance invested in sterling-denominated fixed-interest securities, including corporate bonds, preference shares and convertibles. Unicorn Asset Management manages the former, while Premier Fund Managers runs the latter.

Speaking with the Unicorn managers, they suggest that smaller companies in general represent good value. History confirms the sector outperforms the wider market over the long term for very good reasons. But a recent period of underperformance has left the sector standing at a discount to the FTSE 100 index – with forecast 2015 price-earnings ratios of 14.3 versus 15.1, respectively – while offering superior earnings growth of around 2-3 per cent. With the economic recovery in its early stages, now is a good time to build positions.

AIF focuses on identifying good-quality companies supplying growth markets, with strong cash generation and a growing dividend – the portfolio’s 38 companies on average yield around 4 per cent. This is coupled with a determination to seek value – PEG ratios of less than one being common. This leaves AIF comparing well against its sector on valuation terms. The portfolio’s forecast 2015 rating is under 13 times, while offering earnings growth in excess of 10 per cent.

But AIF also helps to diversify income generation. Some high-profile dividend shocks have in recent years reminded investors of the risks of over-relying on the FTSE 100, despite it generating nearly 90 per cent of the FTSE All-Share’s income. Reliable dividend sources further down the size spectrum are being increasingly sought. This is something I am exploring further in my website’s thematic portfolio, for history suggests decent yielding smaller companies have performed extremely well.

Investors should also be aware that, being part of a split capital trust, AIF is substantially geared courtesy of the zeros. This has benefited investors when markets have risen but, in theory at least, should also make for greater volatility.

Interestingly, in part because of the portfolio’s equity focus on dividends and because the fixed-interest element helps to counterbalance the gearing provided by the zeros, AIF has historically displayed less volatility than either its peer group or the indices – despite its excellent long-term performance. This is reassuring. Furthermore, the managers can nuance the risk profile of the portfolio by, for example, reducing the equity exposure towards the lower end of its 70-80 per cent range and shortening the duration of its bond exposure.

In short, AIF is run by respected teams, has a good track record, currently sits on a 15 per cent discount – twice its recent average – and yields 4.2 per cent. This is an attractive combination. Meanwhile, there is a continuation vote due in August 2016.

There were no changes to either the Growth or Income portfolios during April.