Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Hugh Yarrow, manager of the four-star Evenlode Income fund warns investors to expect lower growth in the future from UK equities.
Profit warnings and dividend cuts have been on the rise in the UK, particularly for stocks with exposure to the energy, industrial metals and capital goods sectors. Companies closer to the consumer are in general fairing relatively better, but even for these businesses life is not particularly easy. At the same time, the valuation environment is not as attractive as it has been.
For the patient investor, unfashionable investments will be the most rewarding over the longer-term
In my view, UK equities are priced to deliver lower returns over the next five years than they have been over the previous five years. The outlook for dividend growth also looks lower due to rising pay-out ratios, with the outlook for dividends particularly compromised in the capital-heavy resources sector.
The reality is that even the most predictable business will not necessarily grow earnings in a straight line. Headwinds crop up – at the macroeconomic level, industry level and individual stock level. As a result, earnings tend to bump around in the short-term. Income investors need to think about what long-term free cash flow, and thus dividends, a company is capable of generating.
Our focus as we head into 2016 is, as usual, on asset-light companies with strong free cash flow. We are also attracted to companies that benefit from repeat-purchase business models. These characteristics tend to help produce more sustainable dividend streams. Key sectors for the fund include consumer branded goods, support services, healthcare, software, media and speciality engineering companies. Conversely, the fund has no exposure to several capital-heavy sectors including energy and mining producers.
In terms of valuations we look to achieve an appropriate balance between quality, value and dividend yield in the portfolio. In the uncertain economic and market environment of the last two years, some high quality businesses with operational momentum have seen very strong share price performance, leading to compression in their dividend yields and forward return potential.
This trend means we are most interested at present in quality businesses with short-term operational headwinds, e.g. currency headwinds or an industry slowdown, where valuations are looking more attractive as a result. For the patient investor, unfashionable investments in fundamentally attractive businesses are often some of the most rewarding over the longer-term.
