Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Hugh Yarrow, Co-Manager of the Evenlode Income Fund.
Hello, Hugh.
Hugh Yarrow: Hi, Emma.
Wall: So, we've heard this week that Brexit really does mean Brexit. And one of the things if we put the economic implications aside for investors, is how the stock market has reacted since we had that vote to leave and that's been that large-caps have really outperformed small and mid-sized companies. And because of that those companies are looking more expensive now and I know that you have a screen to indicate an investable universe for Evenlode Income. So, have you seen now those much larger companies become too expensive to invest in?
Yarrow: Well, I wouldn't want to generalize too much. I think immediately after the Brexit vote there was a fairly sharp reaction, particularly in mid-caps and particularly those that do have exposure to the U.K. domestic economy. And we saw some good opportunities to add to existing holdings in the mid-cap sector, but also a couple of new positions as well that we brought into the fund.
Having said that, a lot of those companies then actually recovered reasonably well. And so, the sentiment towards mid-caps thus deteriorated, certainly not sort of desperately negative and there's quite a lot of domestically-exposed companies in our investable universe, very high-quality businesses, strong balance sheets, high free cash flows that we would be very interested in investing in if sentiment did deteriorate further over the next few months or over the next couple of years. So, we are keeping a watch on that.
In terms of large-cap stocks, I mean, I think part of the rally has very much been about currency. Clearly, sterling has depreciated significantly and that's beneficial to the multinationals in the FTSE 100. It's also partly been about the recovery in commodity and oil prices, which is obviously a big sector of the FTSE 100, too. We continue to see some good valuation opportunities in large-caps too, but it's very stock specific.
Wall: And will we expect that to continue, because of course Brexit is still quite an uncertain concept. That uncertainty is part of the reason why sterling has devalued so much. So, 2017, are you expecting it to be another year for large multinational companies?
Yarrow: Well, it's certainly a tailwind for them at the moment. And if currency stays where it is today, then some of these companies saw some benefit to their earnings and cash flow last year, but really that will come through more significantly in 2017. And I think it's interesting from a dividend perspective. I think I said last year with you, it's very, very mixed outlook and you've got a fundamental backdrop that's quite difficult. Economic growth is quite low globally.
Payout ratios have risen. And so, growth rates generally across the market have slowed. But in the U.K., you are now having this offsetting factor of weak sterling being beneficial to earnings and therefore, a slightly better outlook for dividends. So, there was modest growth last year. It would have been a decline if it hadn't been for sterling. This year again a difficult backdrop but it will be helped by the currency effect.
Wall: You've alluded to there that the fact that we can't sort of lump all large-caps and all small and mid into a particular bucket that says, has done well, will do well, hasn't do well, won't do well. So, within those, sort of, cap scale where are you seeing the opportunities? Is it particular sectors?
Yarrow: I think – I mean, we always focus on strong balance sheets and high free cash flow generation, businesses that can self-fund their own organic investment. But I think we're particularly conscious of that in the current market. I think particularly with balance sheet strength, debt is very cheap, borrowing has crept up at the market level and I think it's partly a function of the low – generally low-growth economic environment. Businesses are tempted to use debt to buy back shares or make acquisitions to offset low growth.
But clearly, that does come with some risk. And so, where we've seen good opportunities to buy businesses on attractive valuations, attractive dividends, but crucially where the balance sheets are strong and the free cash flow is healthy. That's really where we've been focusing. And that's a fairly disparate group of stocks, but that's definitely a trend that they all share, a characteristic that they all share.
Wall: Hugh, thank you very much.
Yarrow: No problem.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
