Are Banking Stocks Worth Considering for Income Investors?

THE INCOME INVESTOR: When the big banks cut their dividend payments in the wake of the global recession income investors felt the brunt. Are they returning to the table?

Holly Cook 15 October, 2015 | 8:45AM
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Holly Cook: Hello, and welcome to Morningstar. I am Holly Cook, and joining me today is Dan Hanbury. He is Manager of the River and Mercantile UK Equity Income Fund.

Dan, thanks for joining me.

Dan Hanbury: Good Morning.

Cook: So, in choosing stocks from the universe within U.K. equity, in order to provide that income for your investors, how important is the outlook for the U.K. economy because, of course, it's been quite a strong growth that we've seen relative to other developed countries, but we're still worried about inflation-deflation, how important is that to you and your process?

Hanbury: It is important. We are very much based on stock selection, I guess like a lot of managers, so we do look at macroeconomic risk at a risk management level and we do that on sort of quarterly basis; but generally, there is a lot of noise around economics, macroeconomics.

Economic growth is often a lagging indicator when you are looking at the stock market. So, you have to be a bit careful not to focus on where economic growth is today; you got to think about the lead indicators about where we are tomorrow. So, it is very interesting; if you go back about three or four years, people used to think about the U.K. economy as being a bit of basket case. They were saying, you must invest overseas, don't touch anything here and it's amazing how four years on how we've had a nice recovery. We're finally starting to see some wage inflation coming through.

And it's interesting, a lot of the U.K. domestic stocks, of course, have performed very strongly and including the income related stocks, so the general retailers, the ledger stocks, the housebuilders were being very, very strong and actually we've been taking money of the table in that area over the last few months because they in terms of the cyclical areas of the market as the domestic cyclicals that have been the strongest and actually if anything the incremental news is likely, more likely to be bad news.

Interestingly, U.K. consumer confidence hit a 30-year high in couple of months ago, and there is very good piece of research that shows how that as an economic indicator is actually very useful and it's a contrarian indicator actually for the domestic stocks. Now fortunately, as lot of people know there was a lot of international exposure in the U.K. market, 70% of the profits coming from overseas, so we're always looking to reallocate capital to really interesting high-quality businesses, growth businesses, indeed recovery in asset-backed businesses from not just the U.K. economy, but expose to across the world.

Cook: You mentioned few sectors, the housebuilders for example. I know that within the portfolio, you are sort of – have sort of 30 companies small caps, 30 midcaps, 30 large cap; is that very deliberate or do you tend to find sort of better income opportunities in specific capitalisation brackets.

Hanbury: No, that's not a fixed ratio, that just happens to be where we are now. It's very broadly spread which is quite unusual. Normally, we would have portfolio of 60 to 70 stocks a little bit more focused and that's when we would typically have a lot of high-quality businesses in the portfolio, but what's interestingly happened over the last three or four years is that because of the high-quality great segment of the market has done so well on those stocks that have done best for us in our portfolios too.

Because they have done so well we've actually now started to reallocate during this year, during 2015, much more to the sort of recovery in asset-backed end of the market because they tend to be earlier-stage, slightly higher-risk, higher-reward, we tend to have smaller positions and we just diversify the portfolio a little bit more in that scenario.

So, for example, some of the financials, buying bank stocks maybe the first time for income portfolio. So, there are great yield opportunities in all areas of the market, particularly the mega caps at the moment and indeed, the small caps.

We always find great yield opportunities in small caps; there's always great alpha opportunities. But of course, there's been very interesting dynamics in the large caps as well with certain areas of the market being very strong, some of the high yielding companies. But also clearly the cyclical end of the market being very, very weak. We are looking for opportunities in that area of the market at the moment.

Cook: So looking forward in terms of sort of how you're going to go about your everyday business of picking these stocks. What would you say is the sort of main concern or perhaps the main risk on the horizon that sort of keeps you vary?

Hanbury: I think the main risk actually for investor at the moment is to be too worried about the risks. I think we're all so focused on capital preservation, because of the global financial crisis because we've had a sell-off that's being quite aggressive through the third quarter. It's very easy to get very, very defensive at this point in time and a lot of the indicators we are looking at suggests that there is a lot of fear come back into the markets.

There are a lot of parallels I think with the 1998 Asian crisis sell-off and indeed in terms of the price action very similar to 2011 when we had a big sell-off in the third quarter. Our view is it's more like those sort of times, then it's not worse than that, that actually a lot of underlying fundamentals are pretty strong at the moment. We think there is strength in the U.S. economy.

We don't necessarily worry too much about some of the slightly weaker indicator we've seen recently. We think there's real strength in wage inflation is coming to. We do expect a rate rise at the end of the year and we think that's because the economy is picking up quite strongly. I suspect in the U.K. an interest rate rise will follow sometime in 2016.

Similarly, on China, there's a lot of bearishness around China that has a big influence on our market with the resource stocks and indeed some of the big financial stocks. And again, there we think it's not quite as bad. It's not forgone conclusion that the slowdown in China is a bubble burst and it's going to collapse. We think there is an adjustment from those 10% GDP growth rates to 5% or 6%. GDP per capita should improve.

But we think there's a wonderful opportunity on a 15 to year outlook to still buy into EM and I think you're getting one of these chances in your lifetime if you like to get back in on that fantastic growth trend now because you've had three or four years of underperformance and there's real fear in there at the moment. And I think the non-resource related countries like China, India, these are – there's real opportunity there now. And I think we if we can get exposed to those through some of the more Asian related stocks that's really exciting at the moment; yeah.

Cook: Great. Well, Dan Hanbury, thanks very much for sharing your thoughts today.

Hanbury: Thank you.

Cook: For Morningstar, I'm Holly Cook. Thanks for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Cook

Holly Cook  is Manager, Morningstar EMEA Websites