PRESENTER: Equity income has been out of favour with investors for a number of years but is it now due a renaissance and, if so, can the income from equities keep up with or even beat rising inflation. I’m Mark Colegate and this is asset.tv’s masterclass in association with Premier Miton. And I’m joined by three members of the group’s equities team to discuss the topic. Here in the studio we have Gervais Williams, Head of Equities and Co-Manager of the UK Multicap Income Fund; Will James, Manager of the European Equity Income Fund; and Jim Wright, Manager of the Global Infrastructure Income Fund.
Well, Gervais, I’ve alluded to there in the introduction that growth has had a really good run. It’s been a tough time for equity income. Why do you think that’s going to change?
GERVAIS WILLIAMS: Well I think there’s two ways of making money. Capital appreciation and that’s been a very dominant theme, particularly as globalisation has driven up valuations of markets, we’ve seen bond valuations and equity valuations have risen, and of course alongside we’ve seen very rapid growth particularly in China and other places. We’re worried now that we think that that may be coming to an end and that’s less buoyant going forward. The other way of making money of course is involved in cash compounding: investing in a company which generates income and generates growth in that income over time and as you retain that income and reinvest in that income then you can make some very good returns irrespective whether markets go up. And we think that there’s going to be more of a balance between cash compounding as well as capital growth going forward.
PRESENTER: With the power of retrospect, if growth has been a style that has worked for so long, so well for so long, why didn’t you change your strategy?
GERVAIS WILLIAMS: Well actually what’s interesting is actually in spite of the fact that we’ve been probably doing the unpopular things, the wrong things, the overall return on the fund has actually kept up with many of the funds which produce capital appreciation. And that’s particularly true recently when many of the capital appreciation funds have actually come back a little bit and our fund’s held up pretty well and generating more income going forward. So overall it’s produced some good returns, but it’s also less correlated with that and that’s an advantage too.
PRESENTER: Will James, running the European fund, what do you think some of the headwinds and the tailwinds are for equity income at the moment?
WILL JAMES: So certainly in the tailwinds I think are, if you look depends on which I suppose sector you look at, but the tailwinds actually I think are inflation. The one thing that equities do tend to deliver is that cash compounding, the growth of cashflow and hopefully organic cashflow that a business is able to generate, and that should grow through time and therefore can allow one to maintain the real value of one’s income. So I think that’s certainly one of the areas at the moment. If you look at interest rates going up, there are a number of different, certainly different sectors, whether it be the financials or even the infrastructure side of things where you have inflation linkage in terms of those returns and sensitivity to interest rates from positive perspective.
The headwinds, which in some respects are related to that inflationary environment, is inflation in its current form going to lead to a slowdown in growth, it probably will to a degree, but will it lead to a recession, and that at the moment is where the market is sort of worrying a bit just generally as to how can that cash streaming be maintained and sustained through time. My view is yes it can be, but at the moment the market does have a bit of a concern over that in terms of the overall macro picture.
PRESENTER: And, Jim, what are your thoughts in the infrastructure space. First of all tell us a little bit about the portfolio you’re running, which parts of infrastructure do you invest in?
JIM WRIGHT: Yes sure so we look at economic infrastructure, which we kind of categorise in four sectors. So we look at regulated utilities and renewables. We look at energy infrastructure, which is largely a North American sector: pipeline, storage etc. We look at telco infrastructure, so anything that supports high speed data, towers, fibre backhaul etc. And we look at transport infrastructure which is across a number of different kind of subsectors: airports, toll roads, the Channel Tunnel, things like that. So that’s how we categorise infrastructure. That’s where we invest.
PRESENTER: And is inflation good for all four of those areas?
JIM WRIGHT: Yes. We always say the sector has a unique characteristic in that when we look across our assets, we’ve got a lot of direct inflation linkage. So you think of regulated assets, very often the regulator will give you a return on assets, a regulated return on assets, which has direct inflation linkage to the local CPI, RPI. And then we have a lot of long-term contracted assets, and again they tend to have some sort of inflator built in. It might be a hard number, but generally again it’s related to local CPI. And then the third point to make is even in areas where we don’t have that kind of regulatory or contracted inflation linkage, our assets do tend to have really good pricing power, because they do tend to be key essential assets. And so we do think, you know, we welcome inflation for our portfolio returns.
PRESENTER: But are you worried about rising political risk, because we’re hearing so much about a cost of living crisis and we’re seeing price rises coming up but that we probably haven’t felt the effect of them yet and won’t do for a couple of months. When those start to kick in might politicians and regulators start going back and saying we need to rip up these contracts and…?
JIM WRIGHT: It’s a good question and, you know, it’s been tried and it’s happened and you’ve basically got two protections. One is the rule of law. It’s very difficult to rip up existing contracts in sensible legal environments, you know, we’ve seen that historically, but look the second protection is, and I’m sure we’ll talk more about this, what we know and what’s been highlighted in the last two months since Russia’s invasion of Ukraine, we need massive investment in infrastructure. We need huge investment in the energy transition, in global gas supply networks, as well as transportation, high speed data. That investment comes from, you know, it comes a little bit from government subsidies. It generally comes from private capital.
So if you start turning the screws on returns from existing assets, the owners of those assets are less likely to invest more capital in growth infrastructure. And so you’ve always got that kind of natural protection that if you want companies to invest and people to invest in infrastructure, you can’t retrospectively cut returns. That just destroys the investment strategy.
PRESENTER: Thank you. Gervais, I want to come back to something that Will mentioned, the R word, recession. If recession does occur, not saying it will but if it does, what does that do to companies that really rely on providing dividend? I mean is that a negative for them, it must be.
GERVAIS WILLIAMS: So typically during recessions, growth is less. It’s often negative for certain businesses, turnover falls. Alongside you often get margin pressure; in other words the profits which you generate on that turnover also goes down and they’re the source of your cash and the cash generation to pay for the dividends. So dividends come under pressure, and we saw with 2020 and the pandemic - we had a recession at that stage - quite a few companies did cut their dividends. And in a way that’s good because any of the less resilient companies have already cut their dividends, which is a good starting point. But going forward, of course, if the recession lasts, then you do find unfortunately those companies which are over-borrowed begin to fail. Unfortunately businesses go into receivership and as that happens of course quoted companies, certainly the strong companies with generating cash and such like, like many of the companies in the income portfolio, actually can continue to generate not just cash but buy those assets from the receiver and actually generate more cash, more growth of cash, more opportunity for the income to be sustained or grow at a time when others are coming under real pressure.
PRESENTER: So what’s the dividend cover on the UK market at the moment and what was it before COVID, just to get some sense, because there’s been a few over the years that UK has had a tendency to overdistribute.
GERVAIS WILLIAMS: Historically the UK does overdistribute. You’re absolutely right. So, from that point of view, the income cover, the earnings and how much income has paid out of them, has varied a bit. It has been around two times in the past. It got down to about 1.6 or even 1.5 before the recession. It’s come up again with the recent recovery of the market and indeed dividends having been cut, but it’s still not at 2. It’s still below 2 at the moment. So the safety margin isn’t massive, but it’s better than it was perhaps two or three years ago.
PRESENTER: And just a quick final question, Gervais, you mentioned there about companies have taken on perhaps debt when rates were lower, we’ve heard a lot about so-called zombie companies over the decade. If you looked at FTSE All Share, it’s about 900 companies in it, without naming names, how many of those would you classify as zombies to date?
GERVAIS WILLIAMS: Zombie companies are formally defined as those companies which are not generating enough cash to pay their current interest bill. And interest bills have been very small recently so it’s been quite a high bar to achieve. Very fortunately there aren’t many quoted companies which achieve zombie status, and there’s quite a lot of unquoted companies which can achieve that and can survive happily for a period, but there are some. I’ve been rather surprised by how well some have performed actually. So it’s interesting. So I may be wrong about their zombie status or maybe they’ll do better than I think, but I do think there’s not very large numbers of them in the UK.
PRESENTER: All right, thank you. And, Will, you mentioned there that inflation can be good for equities, but what level of inflation is good for equities? Is there a point that there’s a sort of tipping point above a certain level, inflation is really bad for equities and dividends?
WILL JAMES: I think it’s been such a long time since we’ve seen inflation of a similar level. I think people are still sort of struck that you have to go back at least 30 years to sort of see a similar scenario and in fact one could argue that the scenario we’re currently in is somewhat unprecedented because the previous 10 years were unprecedented themselves in terms of where inflation went to and what happened from policy support perspective. So there’s no, I don’t think there’s any one figure. I think a reasonable amount of inflation which is reflective of a decent growth backdrop. I think Ukraine and the Russian situation has dented that post-COVID recovery to some degree. But I think if we’re in the sort of 3 to 4 to 5% range, as we probably are, I think that’s probably quite, that is manageable for a number of companies out there. There is a bit of pain being taken at the moment, just because of the dislocation in supply chains, post-COVID and then on top of that post the Ukraine crisis, but over time, and again what really matters is your time horizon, because like all these things things wash out through time.
So if we’re looking at sort of the next sort of three to five to ten years I think we’re in a pretty good place from a cash perspective and a dividend perspective. And, as you said at the outset, the market is starting to think about having to think about dividends as a component of that total return. The last five years, or the last 10 years, dividends really haven’t mattered and particularly in the last five years and, you know, within European markets, within a number of different markets, I mean my strategy is currently yielding around about 4½%, which is already 50% of your long run return from equities. It’s a great starting point. And in some respects with inflation, you probably want to start clipping that coupon so to speak now because it may not be worth as much with inflation going forward if it comes through.
So I think having cash in hand is going to become ever more important for people within the market versus, you know, if you’d been a growth investor for the last four, five years, the last six months have seen capital loss, income I think will be that important component and people are going to start really focusing on it again as they are.
PRESENTER: And this side, you mentioned there that if you like dividends and income being about 50% of your annualised total return from equities, is that particular to the conditions of early 2022 that we’re in now or is that actually about the long run…?
WILL JAMES: Well that’s about the long run average. Again, depending on one’s time horizon, you could look at the last five year annualised period from, if you’re looking on annualised basis over the last five years and look at the European, you know, dividends have contributed to total return, actually income is negligible because of what price, your share prices and the multiple expansion has delivered. But if you look back over the last 20, 30, 40 years, dividends are always are key contributor and up to 50% of that total return. And I think people are going to have to start recognising that again and that puts us in a very strong position.
PRESENTER: And, Jim, if we move on now to valuation. We’ve talked a little bit about the importance of equity income and how it operates, but I suppose the crucial thing for investors is now a good time to be buying equity income type assets. Just in the round, can you give us some idea of what valuation infrastructure’s on if it’s this, yeah it provides utilities, it’s, not to put words into your mouth but you’re sort of implying it’s a sort of solid business but it’s not exciting text. So what sort of valuation is the market putting on that at the moment?
JIM WRIGHT: It varies, because there’s, you know, different assets attract different multiples rightly or wrongly. So in my portfolio you can start kind of five times EV to EBITDA, enterprise value to EBITDA for some of the telco operators that I own, which are depressed because of 20 years of not hitting that cost of capital. I think that’s going to change, hope that’s going to change. And you can then extend that to 25 times EV/EBITDA for some of the telco tower stocks, some of the renewable developers, where the market can see the terrific replicable growth that these stocks can deliver. So, look, on average my portfolio’s about 13 times, there or thereabouts, maybe a little bit less now, now that earnings have rolled forward, you know, I think that’s about, that’s neither cheap nor expensive in my experience.
PRESENTER: Having a quick look at your top 10, one of the holdings you’ve got is BT Group.
JIM WRIGHT: Yes
PRESENTER: Given all of us at some point connect with BT, what’s the story there, why do you like it?
JIM WRIGHT: It’s a rehabilitation story. It’s been a really very badly run company for 20 years. You’ve now got a management in place who understand that putting high speed data infrastructure, putting fibre in the ground, cable in the ground to people’s homes, you know, is what BT should do. So through that Open Reach business, you’ve basically got a four or five-year investment cycle out to the middle of this decade where they’re investing a lot of money connecting millions, tens of millions of homes, premises, directly to high speed fibre infrastructure. Then that stops. Once you’ve done it you’ve done it. After the middle of this decade, your maintenance capex is low and your cash returns are replicable, they’re there for 15, 20 years, and BT suddenly becomes this ridiculous cash machine. And if we’re right on that thesis, it’s an incredibly attractive stock. And that thesis I think is backed up by private equity interest in BT, which we’ve seen over the last few months, and those guys get it; whereas I don’t think the market does.
PRESENTER: What are they providing you in terms of dividend, I’m just getting a sense of, you know, what are you getting paid whilst you wait?
JIM WRIGHT: So BT, you know, when they refocus a strategy they stop paying a dividend for about 18 months. It’s back now. The stock yield’s around about 3%. We can run with that. It’s cash covered, it’s relatively low, but by the end of this decade, the cash returns, the cashflow yield on BT will be a lot higher than 3.
PRESENTER: OK. Gervais, out of the corner of my eye, I sense you wanted to come in there.
GERVAIS WILLIAMS: Well I think actually what’s interesting about BT and many other companies is that actually many of them have been overlooked by the market, they’ve had their own troubles, and in many case they’re in a more stable background where actually they’ve got more support. And I think the same could be said of Vodafone as well. So it’s quite a good sector, because a lot of these sectors, that’s the nature of income investing, we get in sectors which for whatever reason have had a troubled period and it’s the opportunity to buy them when they’ve still got the disadvantages of the past in their share price and they’ve not really reflected the opportunities of the future.
PRESENTER: Again, coming back to the question about valuation, what are sort of the valuations that you can get if you’re buying what you would perceive to be a good quality equity income stock that has perhaps got, I say negative history, I don’t mean the business has been bad, but everyone’s been more excited in growth.
GERVAIS WILLIAMS: Yes well I mean it’s quite interesting really because when you look at the UK, the UK itself has been out of fashion in terms of stock markets, you know, other areas with higher opportunities in terms of growth, perhaps the US stock market unicorns for example, have been in a period where they’ve attracted a lot of investment and their valuations have moved up, relative to the UK which has been very much in the slow lane, and so the valuations in the UK start off in my view below where they should be. When you take on top of that the fact that actually you may get this change in pattern where perhaps people take profits on some of the higher capital gains strategies and move back to into income sectors then you’d expect a rebalancing of that in the first place. On top of that of course you’ve got individual companies themselves, which obviously stand away from the average and you can buy your companies which are below average. And it’s kind of extraordinary because you do actually get sort of patterns of allocation, which means that even now, things are looking better for the FTSE 100, you’re still finding that actually there have been redemptions in UK funds, even with the opportunity going forward. And so you can get into companies which are standing on very low valuations.
There’s a company which we’ve got in the portfolio called Opherian, which is involved in software for example. It has some very good growth prospects. It had some good trading statements this year. That is standing on a P/E of 11 times. It’s got very strong balance sheet. It’s got more than 10% of its cash in net cash terms on its balance sheet, so plenty of margins of safety. And yet the income and the income growth there is looking pretty exciting. Not a big income, you know, we’re talking about 2½ to 3%, but growing quite nicely at a time when perhaps others aren’t growing at all.
PRESENTER: When we’re talking about P/E ratios, what’s the long-term, long-run P/E average for the market? I mean 11 times, is that cheap, fair value?
GERVAIS WILLIAMS: I think like Will says it depends on your timing. I mean if you look on the last five or 10 years of course evaluations have been relatively high. We are talking about markets often being on 15 times or 16 times, quite usual. In the past, of course, when inflation has been much higher, stock market themselves have been on 12 times and sometimes much lower than that, as you’d expect when inflation’s quite rampant in the ‘70s, you know, a lot of the banks like the Midland Bank at that stage were on P/Es of 4. So valuations do change an awful lot. What you’ve really got to keep an eye though is the income. If you can get a decent yield, not only do you get that income, as Will said, but you get the growth of that income over time if you can find the companies which are able to grow in spite of or perhaps because of uncertainties and that they're buying companies from receivership, then it’s that income growth.
So if you assume perhaps you buy a company at a 4% yield and if you assume perhaps the income grows say 3 or 4% each year on average over a long-term period, then that capital appreciation should come through in terms of share price appreciation. Still yields 4 next year and the year after, but it may have got 3 or 4% more expensive because that’s the income growth. So you can get total returns of 7 or 8 on that basis. Clearly if you can do rather better than that, clearly that’s our ambition, then you can deliver much higher returns than that.
PRESENTER: Will, Gervais was mentioning there that the UK as a market on the whole has been somewhat out of favour in recent years, is it a similar story with Europe, always on a bit of a discount to the US?
WILL JAMES: Yes I mean with Europe, it sort of comes to a point where they had, I think they managed the COVID situation like everywhere else pretty well. We were on a sort of fairly, there was a constructive view of the mark generally and then obviously with Europe when it rains it tends to pour. So you end up, in my 15 years of doing equity income in Europe, it’s quite interesting to see that, you know, we’ve had lots of sort of existential crises one could argue, be it the sovereign debt crisis, be it the populist uprisings in the periphery, be it Brexit, you know, all these things have come to sort of challenge that European project. And then you’ve had Ukraine and I would say that’s probably one of the biggest existential crises that we’ve ever seen from a modern Europe perspective.
So yes at the moment is a trading at a discount to the US because the dollar again is being seen as the safe haven, the US is far enough away from Europe, but I think that that misses the point in some respects that Europe tends to emerge from these crises, whatever size they are, stronger. And what we’re starting to see is an acceleration on a number of things that we’ve been positioned for, in some respects similar to what Jim was saying, we’re going to see an aggressive decarbonisation of the economy as Europe sort of fesses up to the fact that they were over-reliant on Russian gas. It was quite interesting to see that the ECB having been fairly dovish from an interest rate perspective are becoming ever more sort of hawkish. And it looks like policymakers around the world are handing the baton over, they’ve said OK we’ve done what we can from a monetary policy perspective, I mean if you think about Europe it’s still on a negative 50 basis point interest rate, so policy is pretty loose, but it’s going to come down to the fiscal response. And I think if one looks at the reaction of Europe I think Putin probably thought that Europe would go back to their infighting around what happened and in fact they’ve come much closer together.
So I think the fiscal response is there. We’re going to money thrown at it by governments because they want to get elected the next time around. But I also think there’s going to be an element of focusing on the self-help element, focusing on those industries that both self-help but also from an M&A perspective. We’ve already started to see businesses who are looking to do M&As last year saying well multiples were way too expensive, valuation multiples were way too expensive, and in the midst of the crisis, you’re starting to see some deals being down as some of the privately held firms turn around and say OK fair enough, we’re quite happy to be part of a bigger group now and people are putting money to work.
So I think in the context Europe looks relatively cheap, but I think that’s the higher risk premia as a result of the Russian crisis. If you look at March, there’s the Bank of America had a stat out there saying it was the largest ever outflow from European equities. So the contrarian in me will suggest that positioning is pretty light. And if I look at sovereign debt crisis, populist uprising, Brexit, everybody panics at the point of potentially maximum pain. And then you’re in a position to identify attractive valuations, attractive businesses where their cashflows are mispriced and underappreciated and on a three to five year view we look pretty well set.
PRESENTER: Thank you. Jim, I wanted to come back to something that I mentioned in the introduction about, hinted that obviously with inflation going up, are you confident that the dividends coming off infrastructure companies or those in your portfolio can at least keep pace with or even beat inflation rates?
JIM WRIGHT: Yes hundred percent.
PRESENTER: Can you talk us through because we’re hearing sort of headline inflation certainly in the UK of about 8% for this year. Let’s assume it’s that.
JIM WRIGHT: Well, go back to BT, right, go back to BT. So in April BT have put through a residential price increase, a price increase for their, most of their residential customers, over 75%, of 9.3%. That’s regulated by Ofcom. Ofcom have said you can put prices up by RPI plus 3.9%: sort of January RPI 5.4%, add 3.9%, 9.3%. So, BT, they employ a lot of people so there’ll be wage pressure. They use a lot of energy so that’ll be, you know, I’m not saying that the costs won’t grow by a similar degree, but you’ve got that top line price protection. And you see that right across the infrastructure space.
Again, you know, another example, we own a stock called Getlink and they own the Channel Tunnel, totally unregulated pricing for passenger cars and heavy trucks going through the Tunnel. They have a competitive advantage in terms of the energy they consume versus the alternative which is ferries and, you know, look at what’s happening with P&O Ferries right now. They are under extreme cost pressure. And that’s partly because of the energy costs and the fact they’re going to start buying carbon certificates this year. You know, Getlink, Channel Tunnel, they’ve got a free rein. They won’t profiteer, but they’ve got a free rein to increase prices. That’s the sort of asset we can invest in. That’s the sort of thing we love.
PRESENTER: And, Will, from your perspective, again coming back to that, because we see a lot of fund managers will say oh we’re growing our dividend or we’re growing our yield more than inflation. I think probably a lot of us got used to that almost happening year by year, it’s almost guaranteed, but if we’re in a period of higher inflation, as an investor, particularly if we are using the income coming off equities for our own income, we’re not reinvesting it, over what time period should we expect a dividend to keep up with or beat inflation?
WILL JAMES: Well, if you, I think if you look at the last, certainly from a European perspective, if I look at the last sort of 10, 15 years of the market dividend, actually up until, well including COVID, the dividend was probably flat to down at an aggregate market level. And that’s partly a reflection of where inflation was, partly a reflection of the fact that we saw a number of sort of, within Europe anyway, issues around the dividend payments, whether it be sovereign debt crisis, whether it be COVID, where actually at that point companies were told they couldn’t pay dividends, for example the European banks. So what pays within that is to be an active manager, that’s what we’re paid to be, we’re paid to be active bottom-up stock pickers. So we can identify those opportunities and be able to grow above that market rate. So, if I look forward, you’re looking with any investment and you can afford to put your capital to work, not worry too much about the volatility of it, a three to five year time horizon, being able to clip a 5% dividend, seems pretty good to me. And even if you didn’t get any growth with that, I’m pretty sure within the portfolio we’re going to deliver at least mid-single digits if not high single digit growth year-on-year 2023 or 2022.
The picture’s a bit noisy at the moment because you saw dividends drop aggressively because of COVID and then they recovered aggressively. So at the moment it's sort of the market’s still trying to work out where we settle down. But if I look at the holdings with the portfolio, balance sheet’s strong, there aren’t, if companies do have debt, the funding requirements are pretty well solidified. We’ve actually seen a number of companies over the last five years sort of refinance quite cleverly in terms of locking in lower rates and for longer. And managements are well attuned to navigating the stormy waters. And we’ve also got to remember that European companies aren’t just exposed to Europe, they’re exposed globally. So it’s not just about what’s your European exposure, what’s the issue there, albeit the problem is at time a crisis, the domicile seems to take over from the revenue and profit exposure. So I think on a three to five year view, starting on 4½% with growth of mid-single digits on a three to five year view feels pretty good to me.
PRESENTER: Thoughts on that.
GERVAIS WILLIAMS: I think inflation may be difficult to keep up with. I think the harder inflation rises in the short term. Probably the slower the growth worldwide because interest rates have to go up further. And so I do think it’s going to be, I do think there are periods when the market can’t keep up with high inflation. So I think we have to keep that in mind. But most particularly the great advantage of cash compounding is that, as you get cash in, particularly if you don’t need the income, you can buy more assets with your income. If the valuations of markets come off because people are uncertain about the rate of inflation and interest rates have moved up, you can buy more assets of course at depressed valuations, which means that when they normalise again, you don’t just get the income, you don’t just get the income growing on the new shares you’ve bought, but you get the cash compounding at a more rapid rate than you would otherwise.
PRESENTER: But that idea of reinvesting. I mean if I think back to the 1990s, total return invest, you bought equity income for income and you bought equity income and reinvested it for total return and capital growth essentially. That story’s rather died away over the last 10, 12 years. How easy do you think it’s going to be to bring it back, convince advisers, and get advisers to convince their clients, that that’s the way to go?
GERVAIS WILLIAMS: Well I think what’s been happening is actually the position’s got so extreme in terms of the interest in income and interest compounding particularly for those people who need total return rather than an income has got to such an extreme, that actually we’re just talking about a tiny bit of rebalancing. It’s not even as though we’re looking for the UK portfolios or portfolios generally to have a much higher weighting of income relative to other assets. We’re just looking for that huge underweight to start to return. So I think from that point of view I think it’s very easy to see my own view. But what’s interesting is if that does occur, and I think that might occur at a time perhaps when the valuations of many of the mainstream sort of capital growth strategies come under pressure anyway and so you’re getting a better total return as well as a better income from cash compounding strategies, that you might actually find that that turns into a virtual spiral where people keep investing in income strategies. They outperform and as they outperform more people want to build larger weightings or reduce their underweightings more and so you get this kind of virtual spiral which will drive it on. And that’s really what I am expecting. I’m thinking it’s going to be quite a long time when actually income and particular income growth over time will start to become some of the best performing assets rather than some of the worst as they have been over recent years.
JIM WRIGHT: Yes I think Gervais is right. I totally agree. I think in a way one of the challenges for infrastructure and particularly when you think about the energy transition and the energy infrastructure stocks is that the growth opportunities are such now that, there will be a temptation for managements to cut dividends. These are natural income stocks. They generate cash. They generate cash on a consistent basis. But if you take SSE, the utility as an example, they’ve basically said that next year they will cut the dividend by around about 30% because they can see such exciting opportunities to invest in the growth in offshore wind. And it’s a challenge, you know, to be candid that’s a challenge for an infrastructure income manager is making sure that we keep the income in the portfolio…
PRESENTER: So how are you, sorry so that sounds like almost a deferred gratification story, being put to you, we’ve got, you know, let’s use the cash now to invest for the long term. As an investor, do you think that makes sense, I just need to make sure I’ve got it or are you getting a bit worried about them?
JIM WRIGHT: No, I couldn’t be more enthusiastic about the generational opportunity to invest in energy transition and I think, you know, it’s something I talk to our clients about all the time. But I’ve got to make sure as an infrastructure income manager that I generate enough income net-net in the portfolio, you know, we can own these growth stories but we’ve got to bring the income through as well, and that’s the charge, that’s the challenge.
PRESENTER: But are you worried with someone like SSE that offshore wind, you’re putting up infrastructure out to sea essentially. There’s been a collapse in price and margin on that as more and more people get into that as a business. If you put it in rough parts of the ocean shall we say with lots of wind and waves, you might think it’s got a 15-year life but it’s got a 10-year life, there’s a danger that they cut your dividend and then they misallocate capital.
JIM WRIGHT: There’s always a danger of that. You’ve got to trust the track record of these stocks, like SSE, like Ørsted, like RWE, they know what they’re doing. The growth in offshore wind, the growth that the EU commission and the UK government are telling you that they need and that they will subsidise if necessary in offshore wind, I think that totally wipes out this lower capital return argument. There’s so much potential for these projects. I think capital returns will be absolutely fine. I think with the likes of SSE are doing exactly the right thing.
PRESENTER: OK. Well I suppose that’s leads us more broadly to the issue of how you make sure you’ve got robust and diverse income, because presumably you want some that’s growing, certain amount of yield that’s paying out today. Will, how are you setting that up because, sorry I was going to say certainly in the past if people have been really reliant on banks, there’s been a point that’s great until it hasn’t been, similarly on the oil companies or tobacco. These big sectors can get switched off as income payers quite quickly. So how do you build that diverse income?
WILL JAMES: The way I see income, I see income is relevant in spite of the last five or 10 years where income’s been less of a focus for the market. My general view is that dividends and equity income is relevant at all points in the cycle. Businesses generate cash depending on what level of cash, and then there’s a decision that needs to be made by management teams in terms of how they allocate that cash depending on where they are in their company lifecycle. So if they want to be investing for growth, then fine, invest for growth and I tend to leave that to the growth investors to deal with because the cash, they’re more interested in that investment into the business to generate that, hopefully that return. I’m much more interested in sort of three opportunity sets.
One is which performs a bedrock of the portfolio is companies that pay a relatively high but sustainable level of income. They may be more mature businesses. But they are generating cash. You could argue they’re sort of cash cows. The big danger there is avoid the value traps, because the market’s very efficient at identifying the fact that you’re basically trading up front income for future capital loss because the business is ex-growth. So again being active, being close to management is identifying that as, you know, being able to identify that risk and identify it early because one thing you don’t want is dividend cut for the wrong reasons versus perhaps a dividend cut in SSE’s case for the right reasons.
Alongside that, there is the benefits that Gervais talks about, which is this, sometimes the purist form of equity investing is this compounding benefit that it gives you, and therefore it’s looking at companies where they may be slightly earlier in their lifecycle but where they are able to generate cash, invest for growth, but are paying a nice dividend which is growing based on previous investment success. Slightly sort of growth phased companies but not so early in their growth phase that we never see any of the cash. And I think dividends for all these areas keep management teams honest. It’s all about ensuring that the management teams understand and reward shareholders in terms for their patience and their loyalty. And then the final element is sort of the element that perhaps was shown around COVID or even arguably now, where the market goes to a very extreme mispricing of dividend potential, or the dividend paying capacity of the company. So a company may be relatively cyclable, but the dividend because it’s cyclable the market goes oh goodness me cashflow’s under pressure, dividends are going to get cut, derated aggressively, yield goes up, and it’s down to us as active managers to take a view and say do we think that dividend’s sustainable and is the market mispriced in that dividend potential.
And through those three opportunity sort of buckets, there’s a level of mispricing of that dividend. I strongly believe that the market misprices the dividend paying capacity of companies most of the time. It’s for us to identify where that mispricing lay. But it’s that level of mispricing. But those three things taken together allow you to build a portfolio which is balanced, relatively style agnostic and allows you to navigate what can be storm waters or through time allows a nice compound return.
PRESENTER: And, Gervais, what are your thoughts on that with the UK Multicap income fund? I say that because I noticed that it [unclear 0:41:10] you’ve got about a quarter of the fund in financials.
GERVAIS WILLIAMS: Yes the financial sector is quite a diverse range of companies and we actually have lots of subsectors in there. So whilst everyone thinks of banks, perhaps it’s only a very small part of the financial sector. You could be invested in incomings which are perhaps in things like CMC where it’s a gaming business, maybe, CFD, and particularly that’s for providing market liquidity. You can get companies in insurance sector, not just one insurance sector, you’ve got insurance underwriters, you’ve got life insurance companies, you’ve got car insurance companies, it’s covered a wide range.
So ultimately although it may be a large sector, it’s a large range of sectors. And the great advantage really of the UK generally, is that there’s a very large number of quoted companies, many of which are listed on the AIM market as well as the main market. Many of these companies are not necessarily very growing as fast as the very rapid growth companies and therefore they are in their own markets generating surplus cash unable to pay dividends, even on the AIM market and in that regard, you can get involved in a wide range of different opportunities which means you diversify risk. The individual holdings, you know, you can have 130 holdings in the portfolio, 130 different parts of the portfolio producing, contributing towards the return and also many of those producing the income. So the income isn’t reliant on one or two companies, it’s reliant on a very large number. And if you get some disappointments, sure to get that, and effectively you still get a relatively good outcome.
PRESENTER: Well, we are pretty much out of time. So I wanted to finish by getting a final thought from each of you. Out of all of the equity income funds that are available, why should investors consider your particular mandate? Jim Wright, let’s start with you.
JIM WRIGHT: Yes I think what infrastructure and infrastructure income fund gives you is an element of safety and predictability from the underlying assets. It gives you access to great long-term global growth themes, the energy transition, the growth of high speed data, etc. It also gives you I think perhaps a high degree of inflation linkage than you would get in a wider income mandate. So I think that’s where infrastructure sort of stands as being a very attractive asset class for income investors.
PRESENTER: Will James?
WILL JAMES: So I think European equity income’s a bit of a specialist sport. There’s not many equity income funds focusing on Europe in particular. The market is deep and broad and therefore within it lots and lots of mispricing opportunities around the dividend paying capacity of European corporates. And I think that’s one of the things because of that, that depth and that breadth, one’s able to differentiate across the market cap spectrum. And be able to deliver a very attractive yield and with it dividend growth, which I think is why I’ve been doing it for so long.
PRESENTER: Gervais, a final thought.
GERVAIS WILLIAMS: Well, the point about the UK is as I said it’s been in the slow lane for many years, partly because it’s a relatively low beta market, a high income market at a time when high beta strategies, the ones which are involved in much more volatile stocks which tend to outperform in rising markets have been popular, so most investors have moved very underweight in the UK as a starting point. And so the great advantage moving into something which is underweight is that as people reweight, you get a little bit of tailwind from that point of view.
The other feature about the UK market which differentiates itself from most other international markets is it isn’t just about large and midsize companies, you can actually get some genuinely small cap and of course microcap stocks on top of that, many of those on the AIM market. And that gives you an opportunity to invest in many companies which are younger by nature. These are companies which are immature, they’re not reliant on global growth in the same way that many of the cyclical companies are and so you can get many of these companies which are actually able to not just produce an income but grow it very nicely, at what we consider, because the UK’s overlooked and small companies particularly overlooked, at a very good entry price.
So from that point of view I’m quite excited because back in the ‘70s the UK market was one of the best performing markets and many of the smaller quoted companies, particularly the small and microcap stocks actually outperform the UK even though that was one of the best performing markets. So the risk/reward ratio at this moment looks as though it may be swinging in favour of a UK strategy in particular.
PRESENTER: We have to leave it there. Thank you for watching. Do stay with us. We’ve got some information coming up in just a second on how you can potentially use this as part of your structured learning. Just remains for me to thank our fantastic panellists: Gervais Williams, Will James and Jim Wright. From all of us here, goodbye for now.