UK Equities – It’s Time To Stand Up

Scott McKenzie, manager of the TB Saracen UK Income and TB Saracen UK Alpha funds, discusses the outstanding value and income opportunities he currently sees in the UK stock market.

UK Equities – It’s Time To Stand Up

Brexit continues to dominate the outlook for the UK equity market. As we write, chaos and uncertainty reign. However, times of maximum uncertainty often present the best opportunities and waiting for clarity may not be the optimum strategy right now.

We have seen global investors flee from the UK with several surveys now showing significantly underweight, negative allocations to UK stocks. The chart below taken from the BOAML global fund managers’ survey demonstrates with stark clarity just how much global investors loathe the UK market.

When we look at the income on offer from UK equities, the arithmetic becomes ever more compelling. Put into a global perspective, the main UK index now yields almost 50% more than the MSCI World. Whilst the UK has long been an income-seekers’ market, the current extreme positioning relative to history feels like a significant anomaly to us.

The UK index yield touched 5% recently and the income opportunities have rarely been greater in our view. If we compare the yield on equities to that available from government bonds, again the readings are at extreme levels. The chart below depicts the yield gap between UK dividend yields and ten-year UK gilt yields – these are now at post war highs.

To put the numbers into context, the historic yield on UK equities is currently above 4.5% whilst the yield on UK gilts is 1.3%; well below any current inflation expectations. Given the ongoing political chaos, we find it unfathomable that investors should wish to lend to the Treasury on such sparse terms and would argue that accepting the ‘risk-free’ rate has rarely been riskier.

An explanation for all of this may be that UK dividend payments are under severe threat. In aggregate there is no evidence to support this, particularly when one considers the huge weight of dividend expectation which falls on the shoulders of our largest companies, many of whom generate dividends in US dollars. The oil, mining and pharmaceuticals sectors stand out here along with giants such as HSBC.

Whilst the high pay-out ratio has indeed been a concern for UK income investors in recent years, the recovery in earnings for the resources companies in particular has seen dividend cover improve and the risks in aggregate reduced.

None of this makes us want to invest heavily in such large, mature businesses however, and many of them will struggle to grow dividends in the long run. Our strategy for the TB Saracen UK Income fund is unashamedly multi cap and our key objective is to continue to grow our dividends to shareholders at least in line with inflation. We believe that investing in a focussed portfolio with a bias to medium and smaller companies gives us the flexibility to achieve this goal without relying on high levels of income from a small number of huge companies whose best days are behind them.

2018 was a year of disappointingly negative returns from global equities, not just UK ones. It’s worth remembering that other major global markets fared even worse than the UK including Germany, Hong Kong and China. Many of the issues facing global investors are universal – rising interest rates, slowing economic growth and the threat of trade wars across key regions.

Despite this difficult background, we managed to grow income to shareholders in the TB Saracen UK Income Fund by 9% in 2018 and it is our firm intention to grow income again in 2019.  The historical yield on the Fund is over 5% today, a level we have rarely seen in the many years we have run equity income strategies.

The case for investing in UK equities has become increasingly compelling and the high dividend yields currently on offer pay investors for many of the risks taken. Whilst the worst-case Brexit scenarios are not pretty, valuations are already extreme and UK shares could recover significantly from here. Waiting for the clouds to clear may risk leaving it too late and missing the sunshine.

It’s time to stand up.

Scott McKenzie, Investment Director, Saracen Fund Managers