Perpetual Income buys banks as a growth play

Perpetual's Income and High Income unit trusts are overweight financials and tobacco and continue to avoid strong exposure to the new economy.

The strategy has served fund manager Neil Woodford well in the past three months with the £2.1bn Income fund ranked second out of 91 in the UK Equity Income sector over three months and the £536m High Income ranked third, on a bid to bid basis.

Woodford is particularly sceptical about the internet's ability to undermine the traditional banks. Both portfolios have their greatest exposure to financials such as Lloyds TSB and Barclays.

In the past few months the share prices of the two banks have been discounted due to the threat posed by the internet.

Woodford said: "The incumbents can survive the launch of internet banks. If you look in the US none of the internet banks are prospering. Barclays and Lloyds TSB already have the capital to enable them to make loans, which is how banks make their profits."

The two funds also have exposure to British American Tobacco. Many fund managers have exposure to the stock because of the yield it offers, at 6.32%, but Woodford believes it is undervalued and the share price can rise, providing a capital growth play.

He said: "Even if you cut out the US business Brown & Williamson, because it faces litigation, the share price is trading below the company's real value. In any case I do not think Brown & Williamson will be made bankrupt from litigation cases in Florida which I think will eventually be deemed unconstitutional."

Woodford is confident the short term strong fund performance can continue and is not the result of a market switch out of tech, media and telecoms. While the three month figures are impressive the one year numbers are less so. Over one year, offer to bid, Income is 85 out of 89 and High Income is ranked 73, the result of Woodford avoiding new economy stocks.

Today the portfolios have less than 5% exposure to pure tech, media and telecoms plays although many of his holdings do have technology angles. Tesco is now the world's largest online grocery retailer and Barclays has built up a large online customer base.

Overall Woodford does not anticipate a large turnover of the portfolios, instead he will broadly stick to the sectors in which he is currently invested. As well as financials he has relatively large exposure to cyclical services, non-cyclical consumer goods and general industrials.

From a macroeconomic standpoint Woodford believes retail price inflation, standing at 2%, will remain within the Bank of England's target of below 2.5%. He said the recent pick up in income growth was a consequence of city bonuses being paid and not a sign of underlying pay rise pressure. In Perpetual's scenario interest rates will peak at, or very slightly above, the current base rate level of 6%.

In the continued low inflationary environment coupled with steady economic growth Woodford warns the only threat to UK equities will be from the US.

He said that the outlook for US technology remains volatile which will have knock on effects on UK companies. He added: "My portfolios should be less affected than others due to their lack of exposure to pure technology stocks."

Although the one and three year performance records of the two frAAA rated funds have been damaged by their lack of exposure to technology stocks, over a five view they have outperformed the UK Equity Income sector.

Between 10 April 1995 and 10 April 2000 the Perpetual High Income fund rose by 83.66% on an offer to bid basis, while the Income fund increased by 90.78%. The sector average during the period was 83.41% with the FTSE All-Share advancing by 130.28%.

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