The Interview 

Defensives and UK domestics offer quality income

Defensives and UK domestics offer quality income

Private investors continue to shun UK assets, with many blaming the economic uncertainty due to the country's scheduled withdrawal from the European Union (EU) next year. But a recent string of takeover bids from foreign companies for British businesses shows UK domestic stocks are undervalued, argues David Smith, manager of Henderson High Income Trust (HHI).

These include Takeda Pharmaceutical's (Jap:4502) bid for biotech business Shire (SHP); US listed International Paper's (US:IP) bid for packaging company Smurfit Kappa (SKG); French real estate investment trust Klepierre's (Fra:LI) bid for property developer Hammerson (HMSO), French tyre manufacturer Michelin's (Fra:ML) bid for industrial belting manufacturer Fennner (FENR), US financial and futures exchange operator CME's (USCME) bid for technology-based service provider NEX (NXG), and US global telecommunications conglomerate Comcast's (US:CMCSA) bid for telecoms company Sky (SKY).

"I think that's a ringing endorsement of how cheap the UK is and how in the longer term things will be better after Brexit, as these [companies] are happy to take the Brexit risk on," says Mr Smith.

While he acknowledges the risk of companies freezing investment because of economic uncertainty, he believes the market is being too bearish. He says Citigroup analysts recently measured the UK market's dividend yield relative to bond yields and found that UK equities have only been cheaper on two occasions in the last century: during World War One and World War Two.

"That speaks volumes of just how much the UK [equity market] has underperformed the global market," adds Mr Smith. "The FTSE All-Share has now underperformed the S&P 500 Index by 27 per cent in the last three years, which is a very dramatic underperformance."

But investors should not lose perspective.

"We're not going back to 2008-09," argues Mr Smith. "The banking sector has been recapitalised and unemployment is still low. Interest rates are moving up, but very slowly. I think investment intentions are still positive across UK companies, so there are reasons to be cheerful. Brexit is an uncertainty but I don't think the UK or the EU will cut off their noses to spite their faces – there will be a bit of compromise. We have got a transitional deal, so no Brexit deal come December 2021 is unlikely."

Mr Smith has been buying what he describes as "good quality" consumer stocks that could benefit from any pick up in wage growth. They include hospitality company Whitbread (WTB), which owns the Costa Coffee and Premier Inn chains, pub operator Greene King (GNK), and retailers Next (NXT) and Tesco (TSCO). The trust had not owned Tesco for several years.

"Tesco's chief operating officer Dave Lewis is very impressive and talks a lot of sense about how he's going to turn around the business [by making cost savings and using them to reinvest in the business], and when you look at Tesco's figures it does seem it is gaining momentum," says Mr Smith.

The consensus opinion is that Tesco will not achieve its earnings before interest and taxes (Ebit) margin target of 3.5 to 4 per cent. But Mr Smith thinks the company will achieve this, and even if it doesn't its investors will be protected by a cash-flow yield of around 10 per cent.

Another underappreciated opportunity, according to Mr Smith, is chemicals company Johnson Matthey (JMAT). Its products include catalytic converters for diesel vehicles, an area that has performed poorly causing Johnson Matthey's share price to come under pressure. 

But Mr Smith says: "[Johnson Matthey has] just announced new battery technology [for electric vehicles] which it claims is better than Umicore (UMI:BRU) – the incumbent's – technology as it is longer range, more power efficient, gives better speed and is cheaper. Those are all good things, which means once it gets commercialised and comes to market the business should see strong growth."

But while Umicore is trading on price/earnings (PE) ratio of 31 times, Johnson Matthey is on a PE ratio of around 14 times. Mr Smith thinks Johnson Matthey is likely to be a long-term winner because of its existing relationships with car manufacturers, which will ultimately lead the valuation gap with Umicore to close.

A few years ago large-cap defensives with predictable earnings, strong free cash flows and competitive advantages within their industry were so highly prized they were nicknamed 'expensive defensives'. However, with global growth powering ahead cyclical companies such as financials, industrials, and oil and mining companies have seized the mantle.  

But Mr Smith argues: "Now, Purchasing Managers' Indices (PMIs) are peaking at a time when global cyclicals are expensive relative to defensives. Some of the big-cap names are yielding incredibly attractive dividend yields. For example, Imperial brands (IMB), BT (BT.A), GlaxoSmithKline (GSK), and National Grid (NG.) are yielding 6 to 7 per cent or above, and that creates a huge opportunity for UK income managers. A few years ago you could only justify [defensives] as being cheap relative to bonds, whereas now they are cheap in absolute terms."


David Smith CV

David Smith is manager of Henderson High Income Trust, which aims to provide a high dividend income stream and the prospect of capital growth. It can invest up to 20 per cent of its assets in bonds and has a yield of 5.4 per cent.

Mr Smith, who is a member of Janus Henderson's global equity income team, is also co-manager of UK equity institutional funds. He joined Henderson in 2002 and initially worked in operations, after which he became a trainee fund manager in the UK equities team with sector responsibilities for media, travel and leisure, and housebuilders. When he became a CFA charter holder in 2008 he was promoted to fund manager.

Mr Smith has a degree in Chemistry from Bristol University.

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