Chelverton UK Equity Income manager David Taylor has started looking beyond ‘dull but worthy’ companies in the search for income outside the FTSE 100.
Until recently, Citywire AAA-rated David Taylor, co-manager of Chelverton UK Equity Income, was fishing in a pool of ‘dull but worthy’ companies with price earnings ratios in high single figures to low teens, good yields and strong cashflow.
‘Like the tortoise and the hare, over a long period of time, these stocks do quite well,’ he said.
However, in the past few months, he has been picking up recovery stocks, like electronic component distributors Premier Farnell, Electrocomponents and Acal. This trio of stocks is yielding 4.7%, 4.5% and 4.2% respectively.
‘They’re all geared to economic recovery and are right at the forefront of GDP growth,’ Taylor said.
Wary of being too gung ho, he has also been adding to positions in more defensive holdings, such as transport operator Go-Ahead Group (yielding 6%), and food firms Dairy Crest (4.8%) and Hilton Food Group (4%).
Breaking from the pack
The fund invests in UK equities with a market capitalisation of £50 million or more, but screens out FTSE 100 stocks. This excludes it from investing in sectors that are the traditional hunting grounds for income fund managers: tobacco, pharmaceuticals and big telecoms companies.
‘That makes us different to every other income fund out there,’ said Taylor. ‘If you go back over a very long period of time, the one bit of the market that is the least looked at is small and mid-cap income stocks.
‘The reason for that is there are a lot of very big income funds: they would love [to own] some of the stocks we invest in, but they can’t because they’re simply too big,’ he said.
Taylor manages the fund alongside David Horner, another small and mid-cap specialist, who is also Citywire AAA-rated. They screen out companies that yield less than 4% on a one-year view, precluding them from investing in two further sectors: mining and oil.
‘All of the small and mid-cap mining and oil stocks don’t yield much: they tend to be trying to find oil or gold, rather than processing it,’ said Taylor.
Risk and liquidity
Is the fund a riskier play, given its small and mid-cap bias? ‘It’s not size that makes a stock risky, but such stocks are less liquid,’ said Taylor.
The fund’s focus means it tends to underperform when investors are more bearish and seeking the ‘safety’ of mega-caps. For instance, Chelverton UK Equity Income underperformed during the credit crunch.
Nevertheless, the fund ranks second out of 90 funds in the Citywire Equities - UK Equity Income sector over the past three years. Over five years, it has returned 72.5%, more than double the 34.3% rise in the FTSE 350 Higher Yield index over the same period.
Chelverton UK Equity Income has had substantial inflows as investors with a number of equity income holdings strive for diversification. The fund, which launched in December 2006, has grown from £39 million to £70 million. Robert Burdett of Thames River Multi Capital is one of a number of multi-managers to invest.
‘When BP cut its dividend, people realised large companies can be risky,’ said Taylor. ‘There was a huge concentration in a small number of stocks among funds producing income, and at that point, investors started looking for diversification and some big funds started buying European stocks.’
Keeping it small
Taylor keeps his holdings small. The largest holding accounts for little over 2% of the fund. The top 20 holdings account for only 19% of assets.
‘Other income funds might have positions of 6% to 7%, but because we believe small and mid-cap income-producing stocks tend to be undervalued, we don’t want to take big stock-specific bets,’ he said.
Looking ahead, he believes that earnings upgrades will start to become more commonplace for UK companies and that takeover activity is likely, which should bode particularly well for companies further down the market cap scale.
‘At some point over the next 18 months, we’ll see some corporate activity and takeovers: historically, that has always happened as we come out of a recession,’ he said.
However, he also hopes the rate of dividend growth will start to slow down. ‘It might sound a strange thing for an income fund manager to say, but companies need to start reinvesting in their businesses. That is what will drive the next cycle of growth,’ he said.