Schroder Income

In the ever-competitive UK equity income space, Schroder Income offers a very different proposition to peers currently stuffed to the gills with expensive defensive stocks.

“People might not be rushing out to buy new flatscreen televisions, they will replace a broken washing machine so demand remains.”

Nick Kirrage

Nick Kirrage and Kevin Murphy took over the fund in May 2010 and suffered a tough first 18 months as their preference for out-of-favour companies was at odds with sentiment. However, the portfolio roared back to the top of the sector over 2012 as favoured banks and consumer names led the market and traditional defensive sectors lagged.Co-manager Kirrage says the central tenet of the pair’s approach is that share price is key and what you pay for a company is more important than what you get from it. “If you look over the last decade or so, traditional income areas of the market such as utilities, staples and tobacco have outperformed and come to be seen as evergreen yield sectors that should always be in this type of fund. “In fact, the reason they have done well is they were so cheap: a decade ago, investors felt tobacco would offer litigation and no growth while utilities would offer regulation risk and no growth. In reality, these have always been good businesses with solid cashflows and gave investors great returns because starting prices were so low,” he adds. For Kirrage and Murphy, the key to building an income fund is not simply buying highyield parts of the market irrespective of valuation but seeking out the best yield opportunities over the next decade.Despite the pair’s focus on long-term returns, the fund clearly enjoyed a strong surge last year and Kirrage says some clients have expressed concerns about what they expect to be a ‘steady’ portfolio doing so well. “We would highlight the fact that today’s cheap stocks in banking and retail are correlated with volatility in a way tobacco or utilities are not,” he adds.“That said, our view is these remain essentially boring companies hiding in volatile share prices and if you look at our top holdings, the businesses have been around for decades. We try to see volatility as an opportunity rather than a threat: income fund owners are primarily concerned that their yield remains solid and we have worked hard to build that in recent years.”In basic terms, their strategy delivers returns from two sources – most obviously the income companies generate but also, and  equally importantly, capital returns from lowly valued companies improving. “We believe some of the greatest dividend opportunities today are in businesses forced to cut their distribution following the financial crisis,” adds Kirrage.Banks and high street retailers have been key positions in Schroder Income, again highlighting the importance of what you pay for a stock over anything else. Taking banks first, Kirrage says these have been a major hunting ground for income investors for over 50 years but are now seen as basket cases after the events of the credit crunch. For the Schroders pair, they boast similar strengths to the cheap income sectors of 10 years ago, with long-term franchises, high barriers to entry and effective oligopoly status in areas like mortgage lending. “With the credit crisis, many stocks, particularly in the banking space, were forced to cut distributions and we see these names returning to normality – and to the dividend register – as a key driver of growth in market yield. People are talking about unsustainably high dividends from some companies but we would highlight unsustainably low dividends in certain parts of the market.”Kirrage flags up names such as Taylor Wimpey and L&G. “With Taylor Wimpey, the company reinstated its dividend last summer following a hiatus in 2011 but it is important to note a large proportion of capital growth took place before it returned to the register,” he adds.“Another well-known company forced to cut its dividend during the recession was Legal & General. “The share price suffered badly, falling to 23p at its low, but these fears were overplayed and the price is now around £1.50, with the company also raising its dividend by at least 20% for the last two years.” According to the pair, many income investors are reluctant to buy into businesses until dividends are assured, by which point much of the opportunity is lost.They see this as a high price to pay for certainty and a feature of the market that value investors can exploit to their advantage. Kirrage also highlights Taylor Wimpey to show how price trumps macro backdrop as the ultimate driver of return.“Back in 2010, investors were understandably not keen on housebuilders and if you told them the housing market would continue to be depressed, they would have run a mile,” he adds. “In fact, the share price has more than tripled since lows. The same goes for RBS: if you had told people in March 2009 the UK would be facing a triple dip recession today, they would never have invested and missed out on considerable returns.”On the high street retail side, Kirrage and Murphy have long championed stocks such as Home Retail Group and Dixons, with prices depressed as investors remain concerned about debt-laden consumers.“For our part, we contend share prices discount a fair amount of bad news and assign a low probability to companies’ situations improving,” says Kirrage. “Consumers are deleveraging but while people might not be rushing out to buy new flatscreen televisions, they will replace a broken washing machine so demand remains. Some share prices in this area have been ridiculous, effectively implying the economy will worsen forever and never stabilise. When it comes down to risk, Home Retail Group has no debt for example.”Over 2012, Schroder Income benefited from its Dixons Retail holding for example, as the share price reacted positively to Comet’s demise, but Kirrage still sees many high-street names as cheap. “If we bought a company on a PE of two and it goes up 100%, it is still not expensive at a PE of four,” he adds.“Comet’s collapse is an example of what we call the free options value investors can benefit from when they invest in lowly priced businesses, where prices are discounting nothing ever going right again.”