Colin Morton, manager of the Franklin UK Equity Income Fund, presents the benefits of a large-cap-focused income strategy
WELCOME
Colin Morton is something of an expert on UK equity income: he has managed money on behalf of investors for more than two decades and run the Franklin UK Equity Income Fund* since 1995. The fund has delivered a steady combination of capital growth and income over this period. Morton’s large-cap, growth-focused investment process has remained unchanged since he began running the fund and it has helped him navigate a series of bull and bear markets. He explains why he only invests in attractively-valued, good-quality businesses with pricing power and cashflow-generating abilities. He also provides his view on equity valuations, alongside an outlook for how the UK equity market will fare in 2018.
*Franklin UK Equity Income Fund launched on 17/10/11 to receive the assets of the Rensburg UK Equity Income Trust, a unit trust.
THE INTERVIEW
Franklin UK Equity Income: A conservative fund delivering above-average returns
Colin Morton, Franklin Templeton Investments
The search for income among FTSE stocks tends to focus on the small number of mega-caps that account for a large proportion of the dividends paid.
Some fund managers may feel stifled by the dominance of such stocks in the FTSE 100 particularly. However, Colin Morton, manager of the £404m* Franklin UK Equity Income Fund, believes his approach to this part of the index is helping him to deliver a healthy and sustainable level of income at a time when investors need it the most. “Income investors face a difficult challenge currently because they are receiving zero on cash investments while short-dated government bonds of less than five years are yielding less than 50 basis points and 10-year government bonds are only providing 1%. “Many investors in this space can end up dipping into their capital in order to supplement their income,” explains Morton.
Risk-averse
He believes his strategy resonates with investors searching for income due to the fact it is a completely transparent, long-only portfolio.
While many investors feel they need to move up the risk scale and into high-yielding bonds or alternative assets in order to derive a healthy level of income, Morton’s relatively risk-averse, large-cap investment approach has delivered an annual income growth rate of 5.5% over the last 20 years, well ahead of the corresponding rate of inflation at 2%* and the FTSE All Share index. “We take a sensible approach to investing in UK equities and aim to deliver above-average returns without taking on huge amounts of risk,” he says. “If you look at the beta of this fund’s portfolio then it is very evident that we are less risky than our peers in the market.” Morton argues the simplistic nature of the strategy and a focus on good quality and high-dividend paying companies is important in today’s complex economic environment.
Economic environment
Downside protection is also a core part of the analysis process in this strategy and no stock makes up more than 5% of the fund’s portfolio so as to avoid stock-specific risk. In addition, some companies are avoided altogether in order to protect investor capital and maintain the fund’s conservative outlook. He explains: “We would never invest in a stock if future returns were reliant on a single specific issue. “In the mining sector, for example, we recently avoided highly leveraged stocks that were too reliant on iron ore or copper price appreciation. “We did invest in the sector, due to the potential for upside, but stuck to more diversified companies which had stronger balance sheets and better profit margins.”
Yield requirements
Morton explains: “I do not let yield be the sole consideration of the stocks I invest in, which is very important to this strategy. “If a company meets all of our criteria but is not, for example, using its free cashflow to pay as much in dividends because it is growing the business or conducting bolt-on deals they believe will add long-term quality to their business, I don’t want to miss out on it because it has a lower yield.” Morton often allocates a small part of his portfolio to such stocks citing that a “pragmatic and flexible approach” is important alongside his large-cap focus, particularly as he anticipates that many of his lower-yielding holdings will deliver significant dividend growth in the future.
Stock selection
Morton uses a combination of bottom-up and top-down processes to select stocks for the portfolio, which has a minimum of 70% invested in the FTSE 100. “Despite the FTSE 100 being a reasonably consistent list of companies, it’s important that income investors don’t start with a blank sheet of paper,” says Morton.“You must start by looking at where the yield is coming from in the market and analyse what percentage of the overall market yield those stocks account for. “As an income manager, I also focus on the type of economic environment we are in; whether it is a cyclical or defensive cycle, or if I am willing to pay more for high-quality stocks because we are in a low growth and low inflationary world.” Though he understands the ‘lumpy’ nature of the FTSE 100, where around 30% of the market yield is derived from just four or five companies, he tries to take a practical approach, arguing such figures are a “reality of life”.
FUND SNAPSHOT
Franklin UK Equity Income Fund
In association with
The challenge for the UK Equity Income sector over the coming months will not be the often-discussed search for dividends, but how managers will navigate the potential volatility of the domestic UK equity markets. Here, researcher PureGroup’s exclusive analysis of the Franklin UK Equity Income Fund shows how it is positioned against a range of macroeconomic factors, and why the Fund is less likely to be impacted by market declines than its peers.The arrows within each chart depict which direction the specific macroeconomic factor is likely to move in over the short term. The positioning of the fund and peer group on each chart reveals how ‘sensitive’ the Fund and peer group are to each of the factors.Positive sensitivities to a factor indicate an investment is likely to have a positive contribution to its performance if the factor increases or expands. A negative sensitivity suggests an investment is likely to have a positive contribution to its performance if the factor decreases or contracts. The size of sensitivity indicates the relative significance of the expected contribution.
UK default spread is the measure of yield difference between high quality (AAA) and lower quality (BBB) corporate bonds. The reason this factor is analysed here is because it is a good leading indicator of business uncertainty, as during periods of increased market stress investors expect to be compensated more for the risk that they are taking. This causes the default spread to expand as lower quality corporates need to offer a higher yield. Importantly the Franklin UK Equity Income fund is neutral to this factor (which is falling currently), and therefore it is likely to be less impacted by any unfavourable news or increase in market volatility.
Looking at wider equity market valuations, the Franklin UK Equity Income fund has a positive sensitivity to UK dividend yields. The movement of this factor during an economic cycle has two drivers: the overall dividend and its underlying valuation. Long-term central bank quantitative easing policies have led to a broad appreciation of most global equity markets. It is this valuation increase that has the biggest current impact on the factor. The fund’s positive sensitivity means that currently it would face a headwind to its performance. However, if valuations were to fall back, then the Franklin UK Equity Income Fund would be expected to outperform the peer group.
Primarily, there have been two levers that have been used by central banks to stimulate the economy, the first is to reduce interest rates to near zero levels and the second is to have asset purchase programmes to repurchase issued government bonds. Global central banks are all at different stages of progress on their own QE programmes, however most have either started or will be looking to initiate a removal of these monetary policies over the coming months and years. Monetary tightening is likely to see domestic short-term interest rates increase. UK term spreads (the difference in value between long and short-dated government bond yields), are also likely to increase. In both of these scenarios, the Franklin UK Equity Income Fund would have a positive impact to its expected return.
Patrick Murphy is the founder of PureGroup, an independent company that works with management groups to provide them with a range of fund data, macroanalysis and insights that help to enhance client engagement. The PureGroup Forward Perspective Model, has been built with leading US based academics, providing asset managers with macro-economic factor analysis to explain their position against the wider business cycle and against their peers.
Do you think the high dividends currently being paid by some of the mega-cap stocks are sustainable?
Do you believe the UK equity market is overvalued?
Under certain circumstances, they are sustainable and in under other scenarios they are not. The more important point is that the yields on these stocks are high because of the risk. Some well-known managers have dropped out of the IA UK Equity Income sector because they were not willing to buy some of these high yielding stocks and consequently did not meet the sector’s (original) 110% yield requirement. However, I take the view that one of the important reasons for the equity income sector’s long-term outperformance is the willingness of some income fund managers to buy the higher yielding out-of-favour sectors. It ultimately comes down to a compromise: what allocation do I need to have in these companies in order to reach my overall yield target for the portfolio? In the case of oil and gas, the sector makes up around about 15% of the FTSE 100 Index. I have allocated around 8% of my portfolio between BP and Shell and they have done extremely well over the past 12 to 18 months. The jury is still out on their business models and whether or not at the current oil price they will start to pay dividends from cashflow in 2017. But the point is, they are still yielding 6.5% against a market yield of 3.5%. So, I am receiving double the market yield for taking the risk associated with these stocks. I would not invest a large proportion of my portfolio in this area, but neither do I want to avoid them completely.
It is rarely straightforward to make absolute judgements on the valuation of the equity market. Whilst equities, on a price earnings basis, do look quite expensive compared to their long-term average valuations, they actually appear undervalued relative to bonds. In the UK, 10-year Government bond yields are currently 1.3%, this compares to an earnings yield from UK equities which is in excess of 5%. Add on the benefits to equity returns from economic growth and you get to a very healthy equity risk premium. It is this factor which is helping to underpin the equity market at a time when there are few, if any, attractive alternatives. Over the medium term we would expect 10-year bond yields to increase from their current low levels but we believe they would have to rise to over 3% to threaten equity valuations. Our analysis suggests the equity market is already pricing in bond yields returning to a range of 2% to 3%.
Should investors be concerned about inflation and its impact on the market?
As investors approach 2018, how would you describe the UK equity market today?
I would be more concerned by the likely increase in inflation if it was being generated by demand factors. However, the current spike in inflation is clearly resulting from the devaluation of sterling in the wake of the EU referendum. Sterling has fallen by more than 10% on a trade-weighted basis and this has inevitably pushed up input prices which are now being passed on to consumers. I expect inflation to peak in the next few months and start to fall back towards 2% in 2018. It appears increasingly likely that the Bank of England will take the opportunity in November to reverse last August’s ‘emergency’ quarter point cut in interest rates, however, I do not expect this to have a major impact on the market.
Valuations remain elevated, supported by extremely low bond yields and short-term interest rates being close to zero. In 2016, due to significant overseas earnings, the UK market received a one-off boost following the post-Brexit-vote devaluation of sterling. Progress in 2017 has been harder to come by as focus has switched to what the world’s central banks will do next as they move towards the normalisation of monetary policy. Thus far, the UK economy has proved remarkably resilient despite the challenges presented from rising inflation and a squeeze on real wages. GDP growth is forecast to be in the range of 1.5% to 2.0% for 2017, with a modest slowdown in 2018. In this environment I believe it is realistic for investors to expect mid-to-high single digit returns per annum from the UK equity market over the medium term.
FUND MANAGER Q&A
Gerhardt (Gary) P Herbert,
CFA, Portfolio Manager and Head of Global Credit
Gary joined Brandywine in March 2010, bringing with him over 20 years of high yield experience. Previously, he was a Managing Director, Portfolio Manager with Guggenheim Partners, LLC (2009-2010); a Managing Director, Portfolio Manager with Dreman Value Management, LLC (2007-2009); and an Executive Director, Portfolio Manager (1999-2007) and Associate (1994-1998) with Morgan Stanley Investment Management. Gary earned his M.B.A. with Honors from Columbia University, and a Bachelor Degree from Villanova University.
Regina joined Brandywine in December 2010, bringing with her 10 years of investing experience. Previously, she was a Vice President - Portfolio Manager and Senior Credit Analyst, Global Fixed Income with Morgan Stanley Investment Management PLC in London (2007-2010) and held various fixed income analyst positions with Morgan Stanley Investment Management in Philadelphia (2001-2007). She earned her Bachelor of Arts in Communications from the University of Pennsylvania. Regina is based in London.
Regina Borromeo,
Portfolio Manager and Head of International High Yield
Brian joined Brandywine in December 2009, bringing with him over 10 years of high yield and distressed debt experience. Previously, he was co-portfolio manager at Dreman Value Management, LLC (2007-2009); high yield analyst/trader at Gartmore Global Investments (2002-2007); high yield and equity portfolio manager and general analyst at Penn Capital Management, Ltd. (2000-2002); analyst with The Concord Advisory Group, Ltd. (1998-2000); and an international tax consultant with Deloitte & Touche LLP (1995-1998). Brian earned his J.D. from Villanova School of Law and graduated summa cum laude with B.S. in Accounting from University of Scranton.
Brian L Kloss,
CPA, Portfolio Manager and Head of High Yield
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Important Information For professional investor use only. Not for distribution to retail investors. The Franklin UK Equity Income Fund charges all of its management fees to capital. This could lead to a higher level of income but may constrain capital growth. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the Franklin Templeton Investments’ fund ranges. Nothing in this document should be construed as investment advice. Franklin Templeton Investments have exercised professional care and diligence in the collection of information in this document. However, data from third party sources may have been used in its preparation and Franklin Templeton Investments has not independently verified, validated or audited such data. Opinions expressed are the author’s at publication date and they are subject to change without prior notice. Any research and analysis contained in this document has been procured by Franklin Templeton Investments for its own purposes and is provided to you only incidentally. Franklin Templeton Investments shall not be liable to any user of this document or to any other person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission. The Franklin UK Equity Income Fund launched on 17/10/11 to receive the assets of the Rensburg UK Equity Income Trust, a unit trust. Investments entail risks. The value of investments and any income received from them can go down as well as up, and investors may not get back the full amount invested. Past performance is not an indicator or a guarantee of future performance. For more information, visit: www.franklintempleton.co.uk. Issued by Franklin Templeton Investment Management Limited, Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorised and regulated by the Financial Conduct Authority.
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