graham ashby, manager of the dws uk equity income fund, is confident despite many companies deciding not to grow dividends
Graham Ashby, manager of the AA-rated DWS UK Equity Income fund, is upbeat on the outlook for the sector, believing dividends will continue to comprise a significant portion of total return for some time to come.
Ashby took over the fund from Adrian Frost last April, having been with the group for some eight years. Over one year to 18 November, the fund has posted a loss of 19.6%, offer to bid, compared with a sector average loss of -20.9%. Over three years, the fund is down 20.8%, versus a 20% sector average loss.
Strong emphasis is placed on bottom-up stock selection at DWS and Ashby works closely with his 20 fellow UK equity fund managers. These are backed by a 200-plus strong analyst team, all of whose analysis is available to Ashby.
Benchmarked against the FTSE All-Share, Ashby aims to outperform the index by 2%-3% per year and takes a balanced approach, running a diversified portfolio of 80-100 stocks.
What do you look at when selecting firms in which to invest in?
The way we look at companies in terms of whether they are good or bad is to focus on cashflow, in particular cashflow on return on investment.
In simplistic terms, we want to determine whether the company makes decent returns on its investments. Ideally, we look for companies that make returns above the cost of cash and reinvest that in the business.
The other side to this is whether this is already reflected in the share price, which tells you if it is a good company but not a good investment. Ideally, you buy good companies at decent prices.
The portfolio is a mixture of good companies, average companies that are quite cheap and poor companies that are looking very cheap. The correlation between cash returns and performance is much higher than any other measure you can use, such as earnings per share or P/E ratio. When you invest in a company, you are giving them management of your money and they invest it on your behalf, so you want a decent cash return.
If a company cuts its dividend, is that an automatic sell?
No, because we look at cashflow and are looking for companies delivering a decent total return. It does not necessarily mean we sell if the dividends are cut because it may be in the best interest of shareholders. If a company cuts its dividend and uses this capital to invest in the business, you lose it on the income side, but you should gain on the capital side.
Are dividends under pressure in light of the current market climate?
There is no doubt dividends are under intense pressure at the moment and there are two main reasons for this. Profits are under pressure and dividend cover has come down from two times a couple of years ago to 1.6 times currently. More importantly, cash cover is also coming down.
The FTSE ex-Financials is on 0.6 times, which means all dividend payments are out of debt and unless cash generation improves, companies cannot sustain that.
We have had a situation for the past five years or so of no dividend growth in the market and the problem is getting worse. There are also a number of large UK companies, which, even if they do have very strong balance sheets and cash generation, are not growing dividends just maintaining the levels, such as GlaxoSmithKline and Astra Zeneca, but supplementing this with share buybacks.
There was a change in the tax regime a few years ago that made it more efficient for companies to buy back shares then increase dividends, especially if they have got a lot of overseas earnings. US investors are typically not keen on dividend payouts and are under pressure to buy back shares.
If pharmaceuticals and other international-facing companies are under pressure to not grow dividends, are there other sectors income investors can turn to?
A number of other sectors, including manufacturing companies, are under pressure to cut dividends, so you look to more defensive areas to counter that.
As a portfolio manager, it is a struggle to maintain the dividend, so you try to have a balanced portfolio and invest a little bit of money in corporate bonds to counter this problem. Sometimes corporate bonds can be a more attractive way of getting exposure to yield.
How much of the fund do you typically invest in corporate bonds?
We have kept it at 5% but this is under review. Ultimately, it is a UK Equity Income fund and we feel obliged to have the majority of our assets in UK equities. We bought into EMI, MMO2 and BSkyB corporate issuance.
Secondly, there are some high yielding stocks in the market in which we can increase our weightings. In the summer, it was electrical components and we later increased our weightings in Canary Wharf.
Can the hunt for yield push some fund managers further up the risk scale?
We are not prepared to limit our universe of stocks by saying, for example, we will only invest in stocks with a yield of 5%, but we recognise longer term it would be inappropriate to go up the risk scale.
How is the fund currently positioned in terms of market cap?
We have been overweight mid and small caps for some time, partly in terms of yield and partly in terms of value. Most large caps are very heavily analysed by the market and, in the short term, one would expect them to be fairly priced.
Over the long term, we would expect to have more in large caps. The fund is currently 10%-12% underweight the FTSE 100, which is evenly spread between small and mid caps, but it is stock selection that drives it.
For example, Electric Components used to be a FTSE 100 stock and when it fell out, the index funds all sold out, which created value.
What scope does the fund have to take large under or overweight positions?
Individual stocks we can hold plus or minus 3% of their index weighting. We are underweight BP, which is a very large part of the market, and underweight oils as a sector. Its all about risk control as well as protection. For example, you need to hold oil stocks because of the tensions in the Middle East, even if you do not think there is much value to be had there.
The fund's risk profile has decreased since you took over. Has that been a conscious decision on your part or a by-product of stock selection?
Our quants team noticed that Barra, which does tracking error monitoring, updated its databases in October and our tracking error went down. The individual stock under and overweights for the fund structure have not really changed.
Given the fund's yield requirements, does it invest in many pure growth stocks?
We think it is appropriate to have some holdings in stocks whose long-term business model should provide decent cashflow and we hold Sage and Arm holdings. In the short term, some work out and others do not, but ultimately I think there is value there.
In October, when there was a strong rally in so-called growth stocks and a lot of high-yielding stocks did not perform, we did very well relative to our peers. We were underweight Vodafone and overweight MMO2 and some of our competitors probably did not have anything in those two. They were in a part of the market that moved aggressively upwards.
With growth stocks enjoying periodic rallies, is it still a good time to invest in UK equity income funds?
UK equity funds remain a pretty obvious home for people that want to invest in the market and, longer term, believe dividends are going to be a very strong part of total returns.
Equities are yielding 3.5%, which is attractive versus 4.5% from corporate bonds, given the potential for capital growth. There are some property hotspots but the yield on buy-to-let in London over the summer was 3.1%.
Your heaviest sector weighting is financials. How are you playing the sector and what is its outlook?
Financials are a large part of the equity market. We have recently been increasing our exposure to HSBC. We like the Household Bank deal it recently announced and the price it is supposed to pay for the acquisition is attractive.
Our favourite financial stock is still Royal Bank of Scotland. We believe it has a lot of scope to increase the revenues at Natwest and has already been effective at waking up that sleepy organisation.
On the negative side, we have taken money out of Barclays because we are worried about its exposure to bad debts. We remain underweight Lloyds and Abbey National and have been for some time. It is difficult to see how these businesses will turn around in the short term and there are concerns they cut dividends.
FUND MANAGER: Graham Ashby
Ashby joined Deutsche Asset Management in 1994 from Friends Provident.
He took over the group's UK Equity Income fund from Adrian Frost in April 2001.
Ashby started out at Deutsche as a UK equity analyst.
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