Unicorn UK Ethical Income proves good income is attractive

The fund is managed by Fraser Mackersie and Simon Moon, who also run Unicorn UK Income (GB00B00Z1R87), another strong performer with an attractive yield. They decided to set up an ethical version of Unicorn UK Income after one of their institutional investors changed its investment mandate and subsequently wanted an income fund with an environmental, social and governance (ESG) focus. 

Unicorn UK Ethical Income aims for a historic yield in excess of 110 per cent of the FTSE All-Share's yield, over a three-year period, by investing primarily in UK companies that meet its managers' ethical guidelines. Both it and Unicorn UK Income have a small to mid-cap bias, with the managers looking for profitable companies that pay dividends and have the potential to grow. The stock selection process for both funds is the same, apart from the last stage for the ethical fund. At this point Mr Mackersie and Mr Moon screen out stocks according to ethical criteria, which include a zero-tolerance policy towards companies involved with tobacco, gambling, genetic engineering, animal testing and pornography. The ethical fund also does not invest in companies that earn more than 5 per cent of their revenue from the alcohol, nuclear power, and defence and weapons industries.

Unicorn UK Ethical Income uses analysts at MSCI, the index provider and analysis firm, to screen stocks against this ethical criteria. MSCI's research team also looks for "ESG controversies" that may cause reputational risk for a company. These could include issues such as a company's governance structure, impact on the environment, and record on human rights, child labour, and workplace health and safety procedures. Companies found to be involved in an ESG controversy are flagged, with the managers monitoring those with moderate issues and excluding those with severe issues. The managers also exclude companies that may not be breaching the ethical criteria but which they feel are moving in a direction that suggests they will in the future.

Unicorn UK Ethical Income excludes seven of the stocks Unicorn UK Income invests in, such as alcohol-focused companies Greene King (GNK) and Conviviality (CVR). BBA Aviation (BBA) is excluded because it runs a small number of private airfields in the US used for military purposes, and electric components company Acal (ACL) is excluded because some of its products are used within military helicopters.

Victrex (VCT), a supplier of polymer solutions, is excluded because it has a subsidiary that has participated in funding an animal testing program. And as Clipper Logistics (CLG) has contracts with some tobacco companies and ITV (ITV) makes a small amount of revenue from gaming, Unicorn UK Ethical also doesn't hold these.

Ethical income funds can find it difficult to deliver an attractive level of income because they avoid the large tobacco, mining, and oil and gas companies in the FTSE 100 that are responsible for a hefty amount of overall dividends. But as Unicorn UK Income also avoids oil and gas, mining, pharmaceuticals and biotechnology companies, Mr Mackersie and Mr Moon say they have found implementing an ethical focus relatively straightforward.

"When we looked at what the actual difference would be if ran the income fund on an ethical basis, with strict negative screening, the answer was not a lot really," explains Mr Moon. "That's because we are trying to do something very different [to other UK equity income funds], as we think there's an over-reliance on further up the market cap scale for income. If you look further down the market cap scale you get companies that are able to provide a decent level of income and grow earnings. Often they have really easy-to-understand business models, but because they are under the radar of other investors they aren't really appreciated."

For example, one of Unicorn UK Ethical Income's top 10 holdings is Alternative Investment Market (AIM) quoted Somero (SOM), which is highly cash generative and recently increased its dividend payout ratio to 40 per cent and paid a special dividend. Somero manufactures laser-guided machinery used in horizontal concrete placement and makes 70 per cent of its revenues in the US. 

Mr Mackersie and Mr Moon are also excited about high-street greetings card retailer Card Factory (CARD). "Card Factory both designs and manufactures its cards, and sells them very cheaply but at very good margins," says Mr Mackersie. "So we think it will do well in this type of environment, as the competition doesn't have its advantage of being vertically integrated [where a company owns its supply chain]. They've also got loads of self-help initiatives to improve efficiency."

However, Unicorn UK Ethical Income gets two-thirds of its underlying earnings from the UK so could be hit if the domestic economy worsens. Mr Mackersie and Mr Moon acknowledge concerns about the ability of UK consumers to keep spending with increased inflation, lagging wage growth and the uncertainties about the UK's withdrawal from the European Union.

But they add: "We're not being complacent about how things could dramatically change for [smaller UK businesses], but the sentiment that 'business finds a way of doing business' is pervasive," says Mr Moon. "We meet lots of management teams in different sectors all over the country, and we listen to what they say about how life and business is, and generally we're getting a good response. You do see warnings out there - more companies are probably warning more now than they were six to 12 months ago. But we remain confident in our basket of stocks."

Unicorn UK Ethical Income (GB00BYP2Y515

Source: Morningstar as at 15/11/17, *Unicorn Asset Management as at 31 October 2017

Performance

Source: Morningstar as at 15/11/17

Top 10 holdings as at 31/10/17 (%)

Source: Unicorn Asset Management

Sector breakdown as at 31/10/17 (%)

Source: Unicorn Asset Management