As the two managers of the JOHCM UK Equity Income fund reflect on the ups and downs of recent portfolio moves, they also share the reasons why they’re feeling positive about the outlook for their fund as well as the cheapness of UK equities. Their latest analysis is as follows:
Performance
Following two stronger months for the market and the Fund, January saw a market pull back and the Fund underperform. The FTSE All Share fell -0.99% over the period, with the Fund down -2.19%. Looking at the peer group, the Fund was ranked in the 4th quartile within the UK. Equity Income sector in January. On a longer-term basis, the Fund is ranked 2nd quartile over three years, 3rd quartile over five years, 2nd quartile over 10 years and is the best Fund in the sector since inception in 2004. The main detractors in the month were in the commodity sectors. Our largest holding in this area, BP, was up slightly in relative terms, but all other holdings underperformed. In the mining sector, Glencore fell 10% relative, whilst Kenmare (see below) fell 20% relative. The prevailing negative sentiment towards China significantly influenced both the former and the sector overall. Within the oil sector, Diversified Energy continued to remain weak.
Stocks like Ibstock, which had been a laggard, rose in January despite a sluggish trading update. It is very encouraging that the market is starting to look through earnings weakness towards valuation. The other feature is forecasts are, in the main, very prudent. This has meant we have not seen many large ‘misses’, and in some places, we are seeing upgrades (eg Wickes rose 10% following a trading update that guided to the top of a previously wide range of profit expectations).
Our construction/contracting stocks all performed well; Kier was up 21% relative, Galliford was up 14% relative and Costain was up 8% relative. There are still some anomalies in UK domestics and small caps, mainly driven by liquidity issues such as share overhangs. For example, Severfield was down 6% relative, and Eurocell was down 3% relative, despite being the most recent stock to announce a share buyback.
Elsewhere, EasyJet was strong following good results. It is very clear pricing trends will be strong across the next 18 months due to supply issues with various Boeing planes. Drax outperformed as the government announced a consultation on a bridging mechanism up to 2030 for the Drax power station. Mobico and Vodafone were also strong.
In the financials sector, insurance stocks were up slightly, and banks were down slightly. Standard Chartered (down 7% relative) was weak. On the other hand, Paragon, the Fund’s top performer in December due to strong results, continued to rise (up 3% relative). Real Estate Investors rose c.10% relative following the announcement of a new strategy, of an orderly sale of the groups’ assets over up to three years.
This month, one of the Fund’s worst performers was Kenmare. The shares fell in a delayed reaction to a pre-Christmas announcement that detailed (a) lower production expectations in 2024, (b) higher costs on their main capex project and (c) the likelihood that the dividend policy would focus on the payout ratio of 20-40% rather than trying to keep it at a flat absolute level, which had been previously noted. This was disappointing in an absolute sense but was magnified by its proximity to the capital markets day held in Q2 last year, which detailed confident guidance on these points. This has impaired credibility and likely new interest in the stock, which trades on a c.33% underlying free cashflow yield once growth capex, is stripped out (ie it pays for itself in three years). We wrote to the board in late 2022, expressing our view that stocks focused on a single country and a single commodity were unlikely to be accurately valued by the stock market in the aftermath of the Russian invasion of Ukraine. This is exacerbated by broader issues in the UK market, especially in small caps. Our preferred solution at the time was for these companies to merge, to diversify country and commodity risk, and improve liquidity. Currently, our preference is an outright sale of the company to a larger group where the cashflows would be valued more appropriately. The assets with a 100-year lifespan and high market shares have strategic value, and in our view, would attract significant interest. We believe large elements of the shareholder base would agree with this view, and as a result, we have written to the board calling on them to assess strategic options.
Portfolio activity
As described above, there were several large price changes under what appeared on the surface to be a sluggish market. We marked to target weight our construction/contractor holdings – this meant reasonably sized sales in Kier and Galliford, given the extent of the share price moves. We also trimmed our housebuilding exposure as the stocks continued to move higher. Bellway is up 90% from the ‘Truss’ lows, including dividends, and is now hovering just below book value. Whilst we still think there is 20-30% upside, a lower weighting is appropriate. We now have c.4% in this stock and Vistry combined versus a peak of c.5.5%. The proceeds were recycled at the start of the month to stocks that had not started rising, such as Ibstock and those that have still not, e.g. Eurocell.
We continued to add to Hammerson, which is now sized at 1% of the Fund. We also added to other recent addition, TI Fluid Systems, which also had a strong trading update and Page and SThree, which were modestly down after the former (and Hays – not owned) had downgrade statements. We also added to Curry’s and ITV. As noted, Paragon has been one of the Fund’s strongest stocks over the last two months. Like the housebuilders, it still has upside (c.25/30%), but we reduced the weight from being the largest stock in the Fund (c.300bps) to c.250bps. We rotated some of this value into the larger banks that have not been re-rated like Paragon (e.g. Lloyds/Standard Chartered).
Outlook
We believe that the UK continues to be one of the cheapest asset classes globally and is also cheap when compared to its most recent historical valuation range. This cheapness is evident when we compare the Fund, now in its 20th year, to its own history. Regardless of the metric used, the Fund is currently around its lowest valuation since the depths of the Global Financial Crisis. The response to this trend has been evident in the boardroom. On average, 5% of each of our companies were acquired through share buybacks last year. This represents a colossal amount of de-equitisation that will enhance future earnings and dividends. With this year expected to see another large number (we estimate slightly less at c.3-4%), the cumulative impact of these actions is material. Additionally, we anticipate an increase in M&A, with boards increasingly exploring strategic changes to unlock value, such as the Real Estate Investors. The convergence of low valuations, our optimistic prospects for both the domestic and global economy, and interest rates that have peaked is a very attractive combination. With a Fund dividend yield of 5.65% and the compellingly low valuations outlined in this report, we remain confident in the outlook.
