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Threadneedle duo add to 'undervalued' defence stocks

The managers of the Threadneedle UK Equity Income fund explain why they have increased exposure to the beaten-up defence sector.

 
Threadneedle duo add to 'undervalued' defence stocks

The Threadneedle UK Equity Income  fund is one of the star picks in Citywire Selection, our list of fund recommendations. We talk fund manager Richard Colwell about the fund's increased exposure to the beaten-up defence sector. 

Topping up on defence sector

Citywire AA-rated Colwell and A-rated co-manager Leigh Harrison have been increasing their exposure by buying BAE Systems (BAES.L) after the fall-out of the failed merger with French rival EADS. The pair, who also have a 1.5% stake in smaller rival Cobham (COB.L), took advantage when what Colwell terms the ‘bid euphoria’ dissipated, and the company fell from £3.60, buying in at £2.80. The stock was trading at £3.10 on 13 November.

‘Defence is an area of the market that is generally loathed because of its exposure to weapons and armaments and especially to potential cuts in US military defence spending,’ said Colwell. ‘But we are contrarian and expect it to do a little better. BAE has been making structural adjustments and cost savings and it also has the benefit of exposure to other lucrative markets, such as Saudi Arabia.’

The stock now makes up about 2.5% of the £1.5 billion fund and Colwell believes the high probability of the company signing off contracts with Saudi Arabia within weeks will give its profits a sharp boost. ‘Its balance sheet is a lot stronger than many people give it credit for and they have yet to book the profit from the Saudi contract. This could lead to buy-backs later this year.’

He also shrugged off last week’s trading update from Cobham, which warned of slowing revenues. ‘We have very selective cyclical exposure because profitability could come under pressure. But Cobham still has very strong cashflows and we don’t think they said anything last week that was inconsistent with their interim statement [three months ago].

‘People are fixated on one-year price to earnings ratios, but it is all about cashflow. Cobham signalled that their dividend is expected to grow by 10% per year. Overall valuations of defensive stocks look good.’

Adding to top 10 holdings

Colwell and Harrison have also used recent market weakness to top up on a number of resilient defensive stocks that they believe are also exhibiting steady growth potential. Positions in top 10 holdings BT (BT.L), AstraZeneca (AZN.L), Unilever (ULVR.L), Legal & General (LGEN.L), Compass (CPG.L) and Imperial Tobacco (IMT.L) have been added to after recent market falls. Colwell told Citywire: ‘The market has had a strong run from its lows in the spring and we have taken advantage of recent swings in sentiment.’

Elsewhere, the duo have been adding to their holding in Marks & Spencer (MKS.L), which now makes up about 2% of the fund, and have seen strong performance from media groups Reed Elsevier (REED.L) and ITV (ITV.L), as well as insurer Legal & General in recent months.

‘The bedrock of the fund are the more resilient cash compounders – they are all cash generative. We were buying ITV last year at 50p to 60p because we saw it was improving its offer and doing a great job of chasing down the debt.

‘We have also been adding to Marks & Spencer because it is not beholden to the end-market and can still get average sale per visit numbers up. The cash generation is quite good and a huge capital expenditure cycle is ending next year.’

Still shunning banks and Vodafone

The managers are sticking with their zero weighting to banks and also have nothing in telecom giant Vodafone (VOD.L), preferring its peer BT Group.

‘Banks have performed well this calendar year but we think it is still a bit premature. Management might give the view that they are just a year from being healed but we think it will be much longer. They have made decent progress in reducing their balance sheets, but we remain wary of bank equity.’

At the same time, Colwell expects BT’s management to be able to continue to cut costs and the firm’s ability to keep driving traffic towards its broadband operations.

Over five years to the end of October, the fund has posted 20.8% compared with -1.1% by the FTSE 350 Higher Yield index.

Over five years to the end of October, the fund has posted 20.8% compared with -1.1% by the FTSE 350 Higher Yield index.

Citywire Selection Verdict:

Leigh Harrison & Richard Colwell have been consistently among the best in their peer group for many years. They are steady performers who always bear the risks in mind and as a result they have  underweights in the financials, energy and materials sectors, while favouring a blend of consumer services, utilities and healthcare companies with industrial names providing the growth.  We back this fund’s steady approach to outperform in almost any climate for equities.

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1 comment so far. Why not have your say?

Patrick Napier

Nov 25, 2012 at 08:33

Leigh and Richard are not "fashion & fad" chasers and I think that two people tend to be better than one in cautious fund management in that they bounce ideas off eachother and avoid extremes.

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