Exploring value and income in UK equities

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I’m Staci West, and today I’m joined by Simon Murphy, manager of the VT Tyndall Unconstrained UK Income fund. Simon, thanks for joining me today.

[00:10] Pleasure.

Now, the UK continues to remain cheap, but even more so in the mid-cap space where this fund is focused. Yet, we’ve seen the FTSE reach all time highs recently. So is the UK still cheap or is the tide turning for UK equities?

[00:30] Yeah, I mean, I think UK equities are very cheap, you’re right, the FTSE All Share has made new all time highs recently to very little fanfare, I must add. And you’re not really seeing many people sort of cheering about that in the press and so forth. But it’s part of a general move upwards in equity markets around the globe. So, year to date, for example, the FTSE All Share is up about 10% roughly. And that’s broadly consistent with what’s happened in America to say the S&P 500 or even in Europe with the Eurostoxx, that they’re up about 10%, 11% as well. So we haven’t really gone up any more than our global peers. And so that sort of relative differential between the valuation in the UK and overseas markets still exists.

And as you pointed out, actually when you look further down the market cap spectrum, particularly into the mid and small-cap area a) they were much, much cheaper in the first place, and b) they haven’t actually gone up as much year-to-date either. So for example, the mid [FTSE] 250 index in the UK is up about 6% year-to-date. So yes, I would argue very much that there is still tremendous value on offer, so in an absolute sense but even with the sort of moves we’ve seen year-to-date and certainly a relative sense because we’ve broadly matched or it’s slightly lagged some of our international peers.

In terms of the tide turning, I do get the sense that there is a bit more positivity finally coming towards the UK market. I would say it’s pretty early days, is my view. I don’t think we’re seeing a huge amount of flow back into the UK yet, but there are just signs at the margin that people are getting a bit more positive about the outlook for the UK market, but I wouldn’t put it any more than that at this stage.

And one topic that we’ve seen more and more is this idea of longevity and investing for income and retirement needs to be for even a longer period of time than maybe historically. And the UK equity market has provided a rich source of dividend income for investors with around 60% of dividend income coming from just the 20 largest stocks in the market. But your fund is slightly different with your mid cap focus. So without putting words in your mouth where does this fund sit in a wider portfolio for investors looking to generate that income?

[03:01] Yeah, well, I I certainly agree with your sort of opening comment that the income is and remains incredibly important and valuable, and as we age, as populations and more of us retire, that just becomes even more relevant.

And you are right, the UK is and always has been a really good income market, but as you say, 20 stocks in the UK pretty much every year actually, the stocks that are in that top 20 change slightly, but pretty much every year, roughly 60% to 65% of the income from the UK market comes from just those top 20 companies. And I think well, personally, I think you can do a bit better or be a bit more different than that. And that’s what we try and do in our fund, by focussing on the mid cap, we diversify our income away from those top 20 companies. And that does mean our portfolio looks very different, I think to what what you’d say is a standard or traditional UK equity income fund. And so I think there are really good reasons for that and I’d happily go into to all of them, but it does, as you say, it means that our fund looks different.

And so actually when you’re thinking about a portfolio of different income opportunities, and our portfolio certainly alongside perhaps a more traditional UK income fund would certainly make sense. I mean, personally, obviously I’d like us to be the main part of people’s income portfolios, but I understand that our approach wouldn’t necessarily suit everyone. And certainly a blend would be a very good option as well.

Now, correct me if I’m wrong, but I believe that Q1 has been fairly muted in the fund with a few new positions being added. So, is that normal for this fund to have low turnover or does this reflect a lack of opportunity in the market? Maybe just walk us through a few of those things over the last few months and then maybe any changes that you did make.

[04:55] Yeah, sure. I mean, as a general rule, I sort of try to invest on approximately a sort of three-year time horizon. And so you ought to expect my portfolio to see about a third turnover a year. And I have a fairly concentrated portfolio by number of stocks, so 35-ish stocks in the portfolio at any one point in time. So a third a year, you should see maybe 10, 11 stocks change a year. And you are right actually in Q1 it was a little bit less than that. So, we only introduced one new holding to the portfolio: Savills, the property consultancy business and we sold two stocks out of the portfolio in Q1: Standard Chartered, the emerging market bank, and Glencore, the mining conglomerate. So it is a little bit lower than usual.

It doesn’t necessarily reflect a lack of opportunity. Because we have such a small number of stocks,  there’s always things to be thinking about, but to be honest with you, it more reflects the fact that actually I’ve been just pretty comfortable and happy with what’s in the existing portfolio. I still think we’ve got huge amounts of upside potential in the fund. We’ve been through reporting season the first quarter, most of my companies have reported and I’ve been pretty happy with their progress. So it’s really been a reflection of just being comfortable with what we’ve got rather than a lack of opportunity. I do try and keep it sort of ‘one in one out’. So if something new is going to come into the portfolio, we will typically replace something existing – not always. And so yeah, that’s the story of Q1 really.

Since then, so in April, so moving into Q2 again, we’ve introduced one new holding which is the industrial engineer IMI, and we’ve sold one position the packaging group DS Smith, which is in the process of being taken over by International Paper in America. So yeah, a little bit lower turnover, but nothing unusual really.

And just following up from that, have you seen an increase in M&A activity for the market but also within the portfolio?

[07:04] Certainly in the market, M&A activity has accelerated really quite sharply year to date. I mean, it started picking up very strongly in 2022, and then there was a bit of a hiatus last year because interest rates were going up so quickly and private equity was a bit more reticent and so forth. It’s really come back with a bang in 2024 so far. And actually some of the M&A activity has been quite big companies as well.

So DS Smith, for example, is a FTSE 100 company that’s being taken over by an American peer. So definitely it’s picked up a lot in the broader market and I think and suspect that will continue whilst UK equities look as cheap as they do. In the portfolio, DS Smith, ironically is the first bid, corporate bid, I’ve had in the portfolio since I’ve been running it actually, so just over four years, which I find quite unusual because I think the portfolio is full of incredibly cheap and valuable franchises. But maybe it’ll be like buses, you know, you wait for a long time for one and then three come along. We’ll see.

And then just finally with the possible reaccelerating of inflation, has left the topic on the table longer than maybe we possibly thought last time that we talked. So I’m just curious, does that change your outlook for UK equities for the rest of the year?

[08:28] For me personally, no. I mean, I’ve been of the view for some time now that we are in a new, somewhat more inflationary environment than the one we’ve been used to over the last 20 years. And so I haven’t really, whilst I’ve expected inflation to come down from the very high levels of last year, which indeed it has, you know, I’ve sort of been of the view that we wouldn’t necessarily go back to the 0%- 2% inflation regime that we were used to. We’d probably be somewhat higher than that. And so that doesn’t surprise me at all. What it has done though is it’s sort of frustrated other players in the market who have been hoping that inflation will come down really quickly and therefore interest rates could start coming down really quickly and all that sort of stuff.

Again, I’m not really that concerned about that. I mean, I think western economies, including the UK actually have coped with the rise in interest rates that we’ve seen pretty well. And actually I think having a proper interest rate, a proper cost of capital again if you like, is something that we should welcome going forward. So I think actually it’s the last 20 years where interest rates were sort of close to 0% for a sustained period of time, that’s the unusual period. So, a little bit higher inflation, a proper interest rate, the economy adjusting and coping, corporates adjusting and coping – I think that’s actually a pretty healthy and probably a more healthy environment than perhaps the one we’ve had more recently. So it doesn’t change my outlook at all, which remains very positive and and I’m hoping that tide will continue turning in terms of optimism towards the UK as the year progresses.

Well, Simon, thank you very much, it was all very interesting and a good overview of the fund.

[10:14] Really appreciate your time. Thanks ever so much, Staci.

And if you’d like to find out more information about the VT Tyndall Unconstrained UK Income fund, please visit FundCalibre.com.