handful of stockpicking uk equity income managers have outperformed sector average during the bear market of the past three years
A handful of UK equity income funds have demonstrated the art of informed stockpicking within a protracted bear market.
Only nine funds in the sector made a positive return over the three years to the end of January, posting bid-to-bid gains of 1.89% to 16.43%. Another 64 posted negative returns, ranging from -0.6% to -74.51%, bid to bid.
Rathbone Income is one fund that has delivered good returns in depressed conditions by deploying a more stock-specific strategy.
Of 73 UK equity income funds, only Credit Suisse's income retail and monthly income funds outperformed the Rathbone vehicle over the three years to 31 January.
Managed by Carl Stick since early 2000, Rathbone Income achieved a three-year return of 14.53%, compared with the UK Equity Income sector average of -18.15%.
Its annualised alpha was 12.23%, compared with the 1.19% average, and its beta was 0.96, compared with a 1.02 sector average.
Though it has grown by £66m since Stick took over, at £75m Rathbone Income is still one of the smaller funds in the sector.
Stick reckoned smaller funds are able to turn size to their advantage during a prolonged downturn: 'A smaller fund can be much more nimble when it comes to stock picking,' he said.
'When a stock market has a fairly strong degree of momentum behind it, funds can quite assuredly buy into sectors. But when it is weak it really does emphasise the ability of the stockpicker.'
Smaller funds taking a 5% position in an investment clearly risk a lot less capital than larger funds, said Stick. 'So it is understandable that the larger a fund is the more it is going to tend towards tracking and be linked to its benchmark, making it take more market-led plays.
'But in these conditions, if you really want to tap into good long-term earnings and dividends streams, whatever the market does, you can only do it by being a stockpicker,' he said.
At the end of January, 46.31% of Rathbone Income's portfolio was in FTSE 100 investments, with 31.42% in FTSE 250 stocks and 12.44% in the FTSE Small Cap.
Though he believed in the market's long-term value, Stick was wary of losing track of sensible valuations in years such as 2002, when general sell-offs meant that even value stocks were hit.
Nevertheless, the 12 months to the end of January 2003 were still a relative success for Stick, falling -16.03% compared with the -24.51% sector average.
Stick added: 'Valuation is important, but what I think I am trying to do now is almost disregard what the stock market is doing.
'I have got to look at individual businesses, such as second-liners on the FTSE 250, and make firm decisions about specific business models.
'We have to go further down the value chain and say to ourselves: that company is making that widget, or that company is profiting through that product. They are getting returns on capital, generating cash, and yielding this amount with a dividend covered, say, two-and-a-half times: they are going to be strong in 12 months time and are worth investing in now.'
Hovering between 50 and 60 stocks, the fund's largest holding is the Royal Bank of Scotland at 2.62%.
The fund is currently underweight in the three major sectors of banks, oil and pharmaceuticals. But Stick said he is still reasonably represented in the sectors just in case the markets bounce.
Pharmaceuticals were show-ing a lack of sustainable yield and growth, he said, but he is drawn to specialist financials.
Anticipating a consumer slowdown and subsequent rise in public and private sector capex spending, Stick has reduced exposure to retail but has gone overweight construction stocks.
Government spending would lift businesses involved in private finance initiative projects, he predicted.
Anthony Nutt is another fund manager who believes in compelling arguments for stockpicking when markets are distressed.
Nutt has managed the £1.3bn Jupiter Income Fund since May 2000. Its three-year return to the end of January was -6.75%, bid to bid, ranking it at 16 in a field of 73. During the period the fund achieved an annualised alpha of 5.08% and a beta of 0.95 and beat the peer group returns average by at least 3% in each of the discrete years.
Nutt said: 'Managers have recognised that people out there have still actually produced positive performance from stockpicking. You need a well-diversified portfolio, you must not risk shooting the lights out with a small number of stocks.'
Nutt, whose largest holding of more than 120 stocks is Associated British Ports at 4% of the portfolio, also noted: 'The market has gone completely out of sync with anything that is promising anything. It is not interested in promises of recovery in corporate earnings, it wants to buy the story when it actually happens ' it does not matter if you are talking about a Unilever or a Logica.'
Nutt said to label some stocks as defensive was now anachronistic, citing pharmaceuticals as an example. This sector's defensive tag, he said, is being undermined by a future of stretched healthcare budgets and controversies over the pricing of new drugs. Nutt is on the lookout for sustainable cash-generative businesses that could continue to perform well. Woolworths is interesting him since it has a free cashflow yield of about 28%.
Since his appointment six months ago, George Luckraft has been changing the strategy of the Framlington Equity Income fund.
Its three-year return to 31 January 2003 was -31.39%, ranking it at 62. Its annualised alpha was -3.62% and its beta is above average at 1.04.
Luckraft has cut the fund's FTSE 100 portfolio exposure from 54% to 35%, with sharp cuts in BP, Vodafone and GlaxoSmithKline.
Luckraft said: 'These represented 22% to 23% when I took over. It felt too much like an index tracker for my liking, so those three now account for around 6.5% of the portfolio.'
Wary of tougher trading environments for the foreseeable future, Luckraft has also gone underweight banks.
The fund, he added, is looking at newer vehicles in Lloyd's of London insurance markets, which had extremely strong ratings cycles in the wake of the 2001 terrorist attacks on the US.
But Luckraft is currently struggling to find enticing broad themes. Overall, stockpicking is the way to go, he said. 'This means I have been increasing mid cap and small cap exposure and am very much sticking to my traditional method of investing in companies where I inspect the management,' he said.
The portfolio is now split about 40% small caps, 20% mid caps and about 5% cash.
Regression analysis: Regression statistics can be used to compare the relationships between funds, markets or a specific benchmark index. They do not make the assumption that the variables (funds) are related as cause and effect, but permit them to be influenced by other variables (markets).
Alpha: The Alpha describes the theoretical reward obtained by one investment when the second investment has a zero return. To calculate the Alpha, the returns of each are taken and compared together to identify their relationship. This reveals relationships between investments in both bull and bear markets. When applied to portfolios, it can be considered to be the return over and above (or below) the market through portfolio strategy. Good managers have a positive Alpha.
Beta: The Beta is the amount the first fund moves when the other moves by one unit. Beta is a measure of relative volatility (absolute volatility is calculated by standard deviation).
If one fund always goes up and down by 1.5 times of the performance of the index, its Beta will be 1.5. This implies that if the return of the index is positive, then 1.5 times this positive return can be expected of the fund. If the index goes up (or down) 10%, the fund goes up (or down) 15%. Beta represents the volatility of the first investment versus the second. It is only an estimate and to be accurate there has to be a perfect correlation between the two investments.
Correlation: Correlation shows the strength of a linear relationship between two funds. A perfect correlation is when the investments behave in exactly the same manner. A perfect positive correlation is represented by 1, perfect negative correlation by -1 and no correlation with a 0. A perfect negative correlation suggests that for every 1% movement by the index we would expect to see -1% movement return on the fund and vice versa. This is an important factor when using modern portfolio theory.
Source: Standard & Poor's
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