M&G income portfolio, managed by HAK salih, will be focus of group's efforts to raise the profile of its equity fund range
Hak Salih is happy to admit his M&G equity income fund's mandate means he is quite likely to underperform his peers in a falling market.
The £312.9m Income portfolio has to be fully invested in equities at all times and Salih does not have the option, unlike many of his competitors, to build up exposure to cash, bonds and convertibles in tough conditions. The flipside to this is that the portfolio should outperform in a rising market.
Salih took over running the fund in October 2000 and M&G is about to embark on a drive to promote its equity income capabilities at a time when it is best known for its fixed interest abilities.
The timing is salient given the recent appointment of Richard Woolnough to the bonds desk, which has once again deflected attention away from the group's equity capabilities.
Performance in the M&G Income fund has been strong over one year and an offer-to-bid return of 4.4% over the 12 months to 11 August lifted the fund into the first quartile. This compares to a sector average return of 1.6% and ranked the fund 18/77.
On the same basis over three years, the portfolio remains third quartile, however, having posted a return of -18.6%, ranking it 40 out of 71 in its peer group.
What has driven the fund's improved performance over the past year?
The first three years managing the portfolio were difficult but the past few months have been a lot easier against both the FTSE All-Share and our peers.
The first hindrance is that we have to be 100% invested in equities and yield 15% above the market. This is a structural disadvantage as many of our peers can hold convertibles, cash and bonds.
However, when markets rise, as of late, we do get a head start, depending on how quickly our peers can sell out of their defensive assets.
We outperformed the FTSE All-Share by more than 5% compounded after charges over the three years to 11 August and the UK All Companies sector by 13.2%, despite underperforming the UK Equity Income sector.
The yield target is also a disadvantage compared to, say, M&G Charifund, which targets a 60% yield premium, so again there are structural reasons the fund underperformed the peer group over the three years to December 2002.
Are there any advantages to the low yield target?
Being low-risk relative to the market and having a low yield premium does mean you can have a more diversified portfolio.
There is also more scope for capital growth but that is worth nothing when the market is halving.
I am more optimistic from here and there is no hindrance at all to me owning a couple of non-yielding stocks in which I am confident, such as Carphone Warehouse. I also own Somerfield, which now pays a dividend, albeit only 1%.
The fund can also have a larger exposure to pharmaceuticals than our peers, as it would drag down the yield on their funds if they went overweight the sector.
Given the volatility of the market this year, how have you been adapting the positioning of the portfolio?
Between February and March, during the build-up to the war, a lot of defensives were bid up due to the uncertainty over the situation in Iraq. The market priced in a prolonged war and a negative outlook afterwards. We held a number of the defensive stocks that benefited, such as Allied Domecq and Diageo.
Mid caps tend to be more cyclical and, at the time, they were pricing in much more negativity. We felt a lot of FTSE 100 stocks were overvalued compared to the valuations and income you could get in mid caps.
We sold out of a lot of FTSE 100 stocks, particularly consumer-related and tobacco companies, and bought into mid caps. We favoured cyclical services, where we went 5% overweight. We were buying them with little downside risk and many had yields around 6.5%, while others offered substantial capital upside.
Following the outperformance of mid caps, are you still underweight blue chips?
We are 16% underweight the FTSE 100 but that is largely by default in that we are finding more attractive stocks in the mid and small-cap arenas.
On the face of it, it looks like the relative value is in the FTSE 100. However, we avoid macro calls and pick stocks on a bottom-up basis.
Large caps are now yielding more than the FTSE 250 but when you look at the FTSE 100, although the yields are higher, a lot of these dividends will come down on a medium-term economic view.
If we are going into another downturn, the FTSE 100 is the place to be. Defensive sectors underperformed after the war as rates were cut and people bought for recovery. If the economic recovery does not come through, defensives will be back in favour.
On the face of it, they should be attractive to income funds. Indeed, from a bottom-up perspective, some defensives are attractive, but not enough to go overweight the FTSE 100 over mid caps.
So you are happy to take contrarian positions versus both the market and your peers?
Yes, income funds are naturally contrarian. Part of the role is looking at things that are out of favour as they tend to yield more than the market. For example, utilities should be of interest but the question is, are they going to get even cheaper?
What is your stance on company visits?
We aim to see every company in the portfolio at least once a year and some more regularly. As a team, we cover 350 company visits every year and have a separate small-cap team.
Mostly companies want to see you after their results have been released but this is inefficient for us. Our added value is to know companies in which we invest well so there should not be any huge surprises. We try to see them earlier and because of the size of M&G, it is a lot easier for us to see companies than most.
We still get occasional surprises but they are often short-term reactions, like when ICI announced a profit warning. We tend to take a long-term view rather than trade a lot and held onto the stock as our analysts focused on the long-term value of the business.
Are you deterred from investing in stocks that pay dividends in dollars?
A lot of FTSE 100 dividends are paid in dollars and if the dollar keeps on looking the way it is, some of them will not come through.
Stocks like Rio Tinto, HSBC, BP and GlaxoSmithKline all declare their dividends in dollars and, year on year, even if the dividend grows 8%-9%, what you receive is flat on last year, given exchange rate moves.
I tend to favour mid caps, which nearly always pay in sterling. If they grow their dividends at 8%-9%, then 99% will manage that.
Do ex-dividend dates have an impact on the buying and selling process?
We have to manage the flow of income and it is important to hold on to as many mid-cap dividends as we can. But because we are running a lower yield premium, although it is important, every now and then we can sell a stock that has gone ex-dividend, especially low yielders such as Granada, where the amount of income given up would be miniscule anyway.
During the falling market, there was no reason to sell them because the yield was more than any capital growth available elsewhere in the market any way.
Is it frustrating that despite the group's best efforts, M&G is arguably still regarded as a bonds house?
M&G has a huge tradition in income investing and launched the first income fund. We run a wide range of successful income funds and a raft of investment trusts covering a range of styles for a range of clients.
We also ran the Scottish Amicable and Prudential Income range and have three income fund managers who work as a team.
We have gone through some difficult times, as all investment houses do, and the income fund has had a difficult three years.
But Charifund is top decile over one, three and five years. The funds in the range will perform differently, particularly over short-term periods, but if they did not it would not be a range.
We expect them all to beat the FTSE All-Share, net of fees, over time, because of our investment style. If we do, we will have justified ourselves to our clients.
FUND MANAGER: Hak Salih
Joined M&G in 1999 and is head of the UK equity large-cap team.
In 1996, Salih joined Hill Samuel following the merger with Lloyds Investment Managers (LIM) and took responsibility for the combined group's UK Equity Growth & Income portfolios.
In 1992, he started his career at LIM.
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