UK Equity Income Option: risk reward balance looks favourable

Current Overview

From the market nadir of December 2018, we have (in general) seen a significant recovery in share prices. With hindsight it appears once again that the time to selectively buy shares is at times of significant uncertainty – if one is brave enough. Hard Brexit (no deal) anxiety and genuine question marks regarding global growth were the predominant reasons behind the worst end to a trading year in a decade. The US market has now rallied a huge 20% (to within striking distance of the highs) as the Federal Reserve have frankly and embarrassingly “u turned” on monetary policy as a result of stock market pressure.  From the autumn of 2018, traders had turned more cautious on the direction of US growth as evidenced by the inversion of the yield curve.  In other words, the market was looking for lower US interest rates going forward if the Fed were intimating (at the time) for more hikes in rates in 2019.  Better late than never (maybe) and the central bank has duly changed its mind, now with no rate rises (perhaps one)forecast this year in a capitulation acknowledgement of what was forward misguidance.  Ideally a central bank is ahead of the curve!If the US economy does still falter, US equity prices are possibly now too high.

The FTSE 100 index has rallied near 12% from the Christmas (correction) lows, if not as impressive, still material enough to much improve portfolio valuations. The mid cap FTSE 250 has risen 14.25%. Thematically what has been largely spearheading the recovery has been the prices of the UK centric (earning) companies, those that were most hard hit into year end.  In the financial sector, Lloyds Banking Group (65.4p) has bounced 30% from the end of last year and Aviva (435.7p) has risen over 20% from the lows. The house building sector has also been a massive outperformer: Taylor Wimpey (183.34p) for example has appreciated 38.5%over the equivalent period. Clearly market timing purchases of any such stocks while clearing up at home over Christmas will have returned handsomely.

Notwithstanding these recent share price movements higher,the valuation of UK listed shares remains attractive. Most often brokers look at PE ratios (sometimes cyclically adjusted) or multiples to earnings and dividend yields achievable on stocks when assessing valuation.  To keep it simple, UK listed company share prices remain much “cheaper” than US shares for example and yield (by way of dividend income) comfortably more.  And there has been a clear-cut reason for this of course. The outlook for earnings of UK companies in the context of Brexit remains unclear at best and therefore the market has struggled to know quite where to value any one stock (in terms of it price) at any one point in time.  Therein of course lies the opportunities for the active stock picker. Whether one seeks out individual company shares for returns (a riskier strategy) or via collective vehicles (such as Investment Trusts) will ultimately come down to the risk profile of the investor.  Both have genuine merits for inclusion in portfolios.

Equity Income space / options explained

Achieving “total return” (share price growth and dividend income simultaneously) is what an equity income investment strategy relates to.  To illustrate, the Edinburgh Investment Trust (646p) for example invests in circa 60 different UK listed companies.  It pays over 4% per annum dividend yield on any capital investment at current prices and is an actively managed portfolio run by Mark Barnett at Invesco Perpetual Asset Management. With a bias for large and mid cap UK (centric) companies, it is currently an attractive (is somewhat contrarian) option.  My view is that the haze of uncertainty relating to Brexit will soon start to clear. This will allow for decision making within UK business to accelerate, spawning growth in the process and it will also re-kindle interest from overseas in investing in the UK.  As mentioned before, valuations of UK companies remain relatively attractive. A weak pound may also act as a handy catalyst for takeover activity in the UK from overseas companies looking to acquire non expensive assets, again as the Brexit cloud is starting to lift.  

The Edinburgh fund has currently no exposure to highly valued consumer discretionary areas (such as Diageo and Unilever), miners (a sector the manager struggles to have a clear view on) or unquoted shares.  The strategy is to with discipline, invest in value, a consistent approach that in time will deliver again in my view, if over the past year it has underperformed.

As a general point, the Investment Trust option (as a listed company) also provides an opportunity to buy shares at a discount to what the Trust’s net assets per share (NAV) are worth. Where a certain geography (say the UK) has been out of favour, the Trust’s share price will often move too far way away from the underlying asset value normally as investors sell or avoid such shares. The Edinburgh Investment Trust for example is currently on a near 8% discount to underlying NAV.  Such a pricing dynamic can also bring about additional opportunity for example ahead of when the geography in question returns to favour. Furthermore, a Trust can borrow money for investment (or gear itself) which is used wisely, can also significantly assist portfolio value and ultimately price.

Investing in direct equities of course is also a way to adopt an equity income approach. The overall income yield of the FTSE 100 is around 3.85%.  Within the index of course are numerous individual company (direct equities) paying in excess of this and importantly, with genuine capital growth potential in addition.  I will mention three examples of such opportunities, all of which at current prices are worthy of potential investment.

BAE Systems(485p). The forward paying income yield on the shares is a secure 4.7% and the shares trade on a PE ratio of 10.5 based on 2019 expected profits.  Current prices are near the low end of the 3 year trading range, down from a high of 680p last summer for a 30% decline. Anxiety relating to a German restriction on exports to Saudi Arabia has affected sentiment on the stock but less than 15% of group profits are derived from SA. With mid to high single digit growth in profits still forecast and with net debt levels very manageable, I believe a target price of around 550p is not unreasonable over the near to medium term.

Royal Dutch Shell(2400p). Forward paying income yield projected to be 6%. The company has not reduced the dividend since the war. A 2019 PE of around 12 falls to 10.5 times 2020 estimates with an accompanying 15% minimum uplift in profits expected across the period. The income yield is paid out every 3 months over the course of the year, certainly useful to the many investors.  Shares are down from 2850p highs of last year and a more buoyant oil price (currently $67 per barrel for Brent crude) should assist the group with achieving its financial targets.

Imperial Brands(2630p). Forward projected yield for next year is 7.8% with dividend paying security cover at around 1.4 (profits could pay the dividend by that factor).Shares are down from 3000p last summer and from 4000p back in 2017. The valuation is not dear in my view on a current year PE ratio of 9.2. Mid single growth in earnings are expected over the next few years with dividend payouts likewise growing in tandem. Consolidation (takeover) potential cannot be ruled out.

And finally something also to be aware of: a secure and growing robust yield is not just very useful to receive, its very existence also helps protect against price downside in the shares in question.


This report was written by Philip Scott, Director at SI Capital on 19/3/19 when the FTSE 100 was trading at 7320.