UK Equities: Why it Pays to be UnfashionableOct 3, 2018

Franklin UK Equity Team’s Colin Morton has experienced many market phases in his 23 years at the helm of a UK equity income strategy. One lesson he’s taken away is that following the crowd has rarely been a successful ploy. Here, he outlines his time-tested approach to income investing and why, against the odds, he’s optimistic about UK equities.

 

Running a UK equity income strategy is all about compromise. But I don’t think that means getting caught up in every market fad or trend.

My experience, developed over 23 years running a UK equity income strategy, suggests one of the most costly mistakes an investment manager can make is to follow the crowd or to change investment style based on market conditions.

A Traditional Approach to Income Investing

My approach has been to stay traditional and old fashioned. I have generally steered clear of whistles and bells such as derivatives or short-selling strategies.

I seek out quality stocks for the long term, looking for businesses with good balance sheets, proven track records and time-tested products.

Certainly, there have been times when that traditional stance has fallen out of favour. There are points in the cycle when markets can get excited about themes and assets that fall outside my comfort zone. A good example of that came during a period from 1999 to 2000, the height of the Dot-Com boom.

At the time, commentators tended to categorise stocks as “old economy” and “new economy”. Perhaps understandably, investors very much favoured “new economy” companies, including technology, media and telecommunications over the so-called “old economy” stocks like pharmaceuticals.

I remember participating in a conference in London at the time. I was the only person talking about traditional income. Everybody else focused on the “new economy” and the fact that everything was going to change.

Of course, we know what happened. Memories of that “Dot-Com bubble” still hang over markets today.

Building an Income Portfolio

When I build an equity income portfolio, I don’t start with a blank sheet of paper. My ambition is to achieve a yield better than the market, so the first thing I need to know is where the existing yield in the market comes from.

My expectation is that everything in the portfolio should contribute to yield, but I’m prepared to accept lower-than-market-average yield for some stocks if I think that company is offering something that we can’t get somewhere else in the portfolio.

Still, I’m not going to pursue assets I’m uncomfortable with just to make up yield. If there is a marked contribution to the market yield from areas I don’t like, I have to find alternatives to make up any gap.

That process generally means finding stocks that are out of favour: Stocks tend to yield more than the market when no one is buying them. To me, these stocks can be more interesting than those considered in style. And while I might not get exciting dividend growth from them, they might find a place in the portfolio if I feel the dividend yield represents an acceptable return.

Of course, I want to be convinced that a company can maintain its dividend. That consideration is a factor in my stock selection process.

Rather than focusing on price-to-equity ratios in valuing a business, I prefer to look at enterprise value to operating profit.

I recognise that when I buy a stock, I’m not just buying the equity of the business, I’m taking on any debt it may have, any pension liability and any lease liability.

I don’t want any surprises.

Short-termism Should Create Opportunities for the Long-Term Investor

During my career, the market has gone through phases when it was quite difficult to find attractive levels of yield—particularly when everyone was very optimistic and valuations were high. There have been other phases where yield has been relatively easy to find. In my view, we’re currently in the second phase.

Uncertainty, particularly over how Brexit will turn out, has created a pessimistic mood about UK stocks in general. But for me, that suggests there should be potential opportunities to be found.

Growing short-termism among many investors is contributing to a valuation gap emerging. Stocks with attractive yields in areas facing challenges over the next three-to-nine months appear good value, while investors are paying multiples for high-growth stocks that they think appear more stable.

The iconic investor Sir John Templeton once said: “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”

That’s a sentiment I take to heart when I survey the UK investment horizon today and why I won’t be changing my approach as fashions change.

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