Backing small and mid caps for income

The outlook for equity income may slowly be improving, but 2020 remains a year that many dividend hunters would rather forget. Payouts in the UK dropped by a stunning 44 per cent on a headline basis last year according to Link Group, with the pandemic effectively washing away eight years of dividend growth. If anything, it reminds us not to rely solely on the highest-yielding markets for income.

Equity income fund managers have had their own lessons to learn. While investment trusts can dip into revenue reserves to maintain a dividend in tough times, open-ended funds have no such protection. What’s worse, most managers rely on a handful of large-cap stocks that provide much of the market’s income, leaving them vulnerable to cuts, suspensions and cancellations such as those that occurred last year.

Analysis published by asset manager Octopus Investments in March 2020 found that 55 out of 84 funds in the Investment Association (IA) UK Equity Income sector listed Royal Dutch Shell (RDSB) as a top 10 holding, leaving them potentially exposed to the oil major’s historic dividend cut a few weeks later. The same assessment found that 25 of the funds listed HSBC (HSBA) as a top 10 holding not long before a moratorium was imposed on bank dividends.

But not all UK equity income managers are tied to blue-chip stocks, with some teams looking further down the market cap scale for yield. It was names like these that stood out last year. Just three out of 86 funds in the UK Equity Income sector made a positive total return in 2020. Two of these, Premier Miton UK Multi Cap Income (GB00B4M24M14) and FP Octopus UK Multi Cap Income (GB00BG47Q440), are known for looking beyond the FTSE 100. Other flexible names such as ES River and Mercantile UK Equity Income (GB00B3KQG447) and LF Gresham House UK Multi Cap Income (GB00BYXVGT82) fared well against the broader sector, even if they ended the year sitting on total return losses. Because of their exposure to domestic-facing stocks, such funds should do well if the UK economy prospers in the coming months.

Unicorn UK Income (GB00B00Z1R87) is also known for delving further down the market cap scale, but this preference was not so obvious from last year's returns. Having been one of the sector’s best performers in 2019, the fund registered an 11.8 per cent total return fall in 2020, despite an uplift for domestic-facing stocks. This put its returns roughly in the middle of the IA UK Equity Income sector and behind the names mentioned above, even though it outperformed some other more flexible funds. Yet Unicorn UK Income’s managers, Fraser Mackersie and Simon Moon, argue that the fund remains well-positioned to capitalise on better times for domestic-facing shares.

"There are few income funds that do something similar – these are the funds that we monitor more closely," the team notes. "Clearly some funds performed better than others last year – even within this fairly small peer group there are a variety of different approaches through sector weightings, market cap exposure and the use of derivatives. There was a wide of range outcomes from the group last year and the funds that produced positive returns during a very volatile year undoubtedly deserve credit. Our approach remains unchanged: with our focus on cash generation and balance sheet strength, and longstanding sector exclusions, we believe this will continue to deliver attractive returns over the long term."

How Unicorn UK Income differs from its peers

While Mackersie and Fraser focus on small and mid-cap stocks, an onus on quality potentially steers them past some parts of the market that have rallied strongly in recent months. Mackersie notes that the fund holds no mining or oil and gas stocks, something that can have different effects on performance. The portfolio dodged the pain of last year’s oil price crash, for example, but is not likely to see any direct gains associated with the commodities supercycle predicted by some this year. They also don't hold pharmaceuticals companies – unlike many peers. Octopus analysis from July 2020 found that 64 out of 84 funds in the IA UK Equity Income sector listed GlaxoSmithKline (GSK) among their top 10 holdings, with 31 funds listing AstraZeneca (AZN) in their top 10 holdings. As Moon notes: “Barely any of our top 10 is held in other [funds’] top 10 lists in the sector.”

The Unicorn team takes a stock-specific approach, looking for companies that have an edge in niche or growth markets. They focus on metrics such as balance sheet strength, return on invested capital and free cash flows, with an additional focus on good dividend cover and a company’s ability to grow the existing dividend. “It’s not an either/or with income or growth,” Moon says. “Every company should be growing earnings as well as having a dividend yield.”

He adds that there is a “balancing act” between a company’s dividend and growth prospects.

The result is a portfolio of just 39 holdings, with a decent level of exposure to domestic-facing sectors such as financial services. Its top holdings at the end of March included Phoenix (PHNX), Telecom Plus (TEP), Sabre Insurance (SBRE), Polar Capital (POLR) and LondonMetric Property (LMP). While the managers care more about the prospects for individual companies than sectors, some industry allocations reflect their views on where further gains could be made in the UK market after the vaccine rally of recent months.

“The domestic outlook is what we’re most excited about," Moon says. "We’ve been there for five years. People talk about it a bit now but the relative benefits of this vaccine rollout have been underestimated. When you think of exposure, the FTSE 100 isn’t a domestic play – you have to go further down the market cap scale.”

Mackersie argues that financials still have strong prospects and Moon adds: “UK industrials haven’t experienced that vaccine bounce to the tune the more obvious Covid [recovery] names have. You’ve seen more consumer-facing stocks that have done better.”

A mixed play on the UK

Mackersie describes the fund’s top 10 holdings as “quite diverse”. Some holdings have fared better than others in the pandemic and a similar pattern can be seen elsewhere in the portfolio.

Retail logistics specialist Clipper Logistics (CLG), a name the team has held since its 2014 initial public offering, has benefited from the boom in online shopping. Retailer B&M European Value Retail (BME), which entered the fund around 18 months ago, also fared well last year.

“They stayed open with essential retailer status and were a large beneficiary of people preferring to do one shop rather than several,” Moon says. “You had customers that wouldn’t have gone there unless they had to. But their experience has created a sticky customer base.”

The team has been taking profits on both these positions in the wake of strong performance.

Other holdings may instead serve as recovery plays or at least regain some ground after a tough 2020. Sabre Insurance, for example, has suffered from a lower number of driving tests taking place amid the pandemic but should prove “well placed when they get back to normal activity”.

But other finance names have been working well. Broker Numis (NUM) has benefited from high volumes of corporate activity, while in the investment space Polar Capital and Brewin Dolphin (BRW) have held up well.

Like many funds of its type, Unicorn UK Income can only run its winners so far. Because of the subsequent fall in yield, strong share price performance can force its managers to at least take profits on shares that deliver the goods – if not sell them outright. One strong performer that has exited the portfolio, Alpha FX (AFX), remains the biggest position in Unicorn UK Growth Fund (GB0031217937) of which Mackersie is also a manager. Another disposal from Unicorn UK Income was discoverIE (DSCV), a strong performer whose dividend increased but lagged share price rises.

The fund’s level of income may seem lower than that of some others, with a historic yield of only 2.85 per cent at the end of March. However, other UK equity income funds with a multi-cap approach have tended to generate roughly similar historic yields, maybe because a degree of caution is warranted in this space rather than simply chasing high yields. And, for example, Premier Miton Optimum Income (GB00B3DDDX03), which has a stated target yield of 7 per cent a year, was one of the worst-performing funds in the IA UK Equity Income sector in 2020.