On the face of it the outlook for the domestic economy appears reasonably robust. Historically high employment levels, low inflation and rising real wages combined with an increased propensity by the public sector to spend and a decent public balance sheet would traditionally represent a largely accommodative investment background for UK centric stocks. However, Brexit and worries over a change of government have curtailed corporate investment and consumer expenditure. The housing market remains a conundrum as there is a well documented shortage of houses, but Brexit fears have kept transaction levels at historic lows.
Whilst we believed the negatives and uncertainties were largely priced into UK stocks a few months ago the severe sell off towards the end of the year has been accentuated by trade wars and a slowdown in global earnings expectations, leaving fewer and fewer marginal buyers of UK mid and small caps. At the same time, we have seen the traditional round of earnings warnings from December year end companies and what appears to be an increasing reluctance on the part of investors to buy indebted companies, although there appears to be no change in lending patterns from the banks. Sentiment has penalised bad news severely and failed to reward good news, and at the height of the recent political confusion it appeared an easy call to bet against UK exposure.
We have suffered as a solely UK mid and small cap fund from this ‘top down’ anti UK sentiment and from a number of ‘bottom up’ company issues. Specifically, there were profit warnings from McColls, Low & Bonar and KCOM and a surprise rights issue from Kier. Interestingly the feedback from the companies that we invest in has in aggregate remained ‘cautiously optimistic’ and, whilst all have thought about the ramifications of all Brexit scenarios in some detail, the consensus is that whatever happens there will be some degree of additional short-term administration or inventory cost. Obviously, no one is currently in a position to make any longer term assessment.
Interestingly the feedback from the companies that we invest in has in aggregate remained ‘cautiously optimistic’
Our reaction to the recent drawdown is the same as it has been in previous periods like this in that we look to improve the underlying quality of the earnings in the portfolio. With a historic dividend yield of approximately 5.4%* we seek to enhance the prospects for capital growth in the fund over the medium term by purchasing a number of new holdings that have been, in our opinion, hugely oversold in the short-term and thus fallen into our investment universe. To this end we have just invested in Senior, Elementis and Convatec, the latter two being stocks that we also hold in our UK Growth fund. The ability to buy higher growth companies in our income fund at times like this is one that has proved to add value over the long-term.
The ability to buy higher growth companies in our income fund at times like this is one that has proved to add value over the long-term.
In previous cycles a noticeable pick up in corporate activity has proved a good arbiter of when domestic equities get too cheap on a cash flow basis and is seen by some investors as a wider catalyst for investment. Whilst we believe that this will continue to be the case, and despite the resilience of the UK economy and relatively low domestic valuations it is evident that there needs to be more clarity with respect to ‘Brexit’ for this to happen. In the meantime, we look to continued aggregate dividend growth across our portfolio to provide some support.