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Leave the equity income lunch or pay up

The Interview

Leave the equity income lunch or pay up

UK equity income investors who have gorged themselves on a small- and mid-cap "free lunch" will have to put down their knives and forks, according to Neptune chief executive officer and fund manager Robin Geffen.

We are in the process of "a changing of the guard in UK equity income", says Mr Geffen. No more will fund managers be able to rely on an easy tide of small- and mid-caps, and stocks with bond-like returns, to drive profits. "Since the financial crisis you have had a free lunch in the UK by focusing on smaller and mid-cap stocks, and UK equity income managers' allocation to those areas has increased from 30 to 40 per cent between 2011 and today," he says.

"The share prices of mid, small and bond proxies have massively outperformed and people have had a very large and long free lunch. But that's now over. This is one of those single moments when you want to let off a firework to tell people that the game has very substantially changed."

He says the large and mega-cap stocks driving the FTSE 100 to record highs in 2016 will be the places to allocate to in 2017, along with the technology stocks that will be able to displace and replace old high-street stalwarts. He holds Microsoft (MSFT:NSQ) and Apple (AAPL:NSQ) within the top 10 holdings of Neptune Income Fund (GB00B8L7B355) and says that "large companies with overseas earnings streams that are completely mispriced will be the place to be for the next five to 10 years".

The fund can invest up to 20 per cent of its assets in US equities and Mr Geffen says a US-listed stock such as Microsoft should be able to reap the benefit of President-elect Trump's plans to stimulate the US domestic economy. But stocks such as Reckitt Benckiser (RB.) have reached unrealistic valuations, he says, as investors have paid through the nose for stable dividends without a thought for a lack of long-term growth.

"Bond proxies have performed strongly in the past few years, but the past five to six years are an anomaly," he says. "Quality growth is now standing at a 45 per cent premium to the wider market so that's another free lunch over. Some share prices have soared despite earnings downgrades. It's now a very dangerous place to be because it's where the herd is crammed in. That's where valuations will come tumbling.

"For example, I love Reckitt Benckiser [which is trading on a share price multiple of 30 times 12-month trailing earnings], but I've had to sell it because it was way too expensive. Its dividend had not grown in line with the share price."

The past decade has been "extraordinary", due to a combination of record-low interest rates and low yields, which have made investors complacent. He adds that interest rate complacency has been "inbuilt" to the market and "that's when bad things happen to those who have fallen asleep at the wheel".

Today less than 30 per cent of stocks now have a yield above that of the market. By contrast, the figure was 50 per cent in 1989, and in 1997 more than 70 per cent yielded more than the market. Although Mr Geffen says he is not keen to "go out and blindly buy banks", he has ventured back into financials.

The fund has 3.3 per cent of its assets invested in US bank JPMorgan Chase (JPM:NYQ) and 3.2 per cent in Wells Fargo (WFC:NYQ), with a further 3.2 per cent in HSBC (HSBA). That is due to his preference for "mega caps that derive earnings from the US and overseas". Other stocks in that category he holds include CME Group (CME:NYQ) and Rio Tinto (RIO).

"The funds that have underperformed in recent years have been those with a large-cap bias," he says. "Historically a large-cap focus has been a headwind, but now it is a tailwind."

Over the past 10 years it has been relatively easy for UK equity income fund managers to beat the FTSE 100 and the FTSE All-Share indices according to Mr Geffen, and stockpicking has been less important as mid-caps have lifted manager profits. But a change is already under way. In the year to date the FTSE 100 has returned 15.9 per cent, driven by a slug of overseas earnings due to the weak pound, and the FTSE All-Share has returned 13.8 per cent. That compares with the two previous calendar years when both indices failed to make even 2 per cent. Only four Investment Association UK Equity Income sector funds have beaten that return so far this year, compared with at least 60 in 2015.

"We benefit from our large-cap focus," says Mr Geffen. "This year will be the first since 2009 in which the vast majority of UK equity income funds underperform the UK All-Share. Most people won't believe it and it will happen again next year. Free lunches don't last for ever and I officially pronounce this one dead."

Robin Geffen CV

Robin Geffen is chief executive officer of Neptune Investment Management and manager of funds including Neptune Income. He founded Neptune in May 2002 and devised its real world investment approach.

Before this he was global chief investment officer (CIO), pensions at Orbitex Investments, which he had joined in 1997 as CIO. He began his investment career at Charterhouse J Rothschild before moving on to Eagle Star, York Trust and Scottish Equitable, where he set up the pooled funds business.

Mr Geffen graduated from Oxford university in 1979

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By Kate Beioley ,
15 December 2016

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