An underweight position in mining and some stock-specific issues have hindered the UK equity income strategies overseen by Fidelity International’s veteran income investor Michael Clark.
Clark, who manages the £1.1bn Fidelity Moneybuilder Dividend and the £552m Fidelity Enhanced Income funds, said both portfolios had run into “performance issues” in 2017.
The funds have underperformed the average IA UK Equity Income fund, which has risen by 6.77 per cent: Fidelity Moneybuilder Dividend has risen by 3.81 per cent while Fidelity Enhanced Income has returned 3.96 per cent.
Performance of funds vs sector YTD
Source: FE Analytics
Clark said: “In 2017 year-to-date we have had another period like 2016 where the basic materials [sector] – that is the mining and materials component – is very strong.”
The FTSE All Share Basic Materials index has risen by 16.61 per cent so far this year, compared with a 6.19 per cent rise in the broader FTSE All Share index.
Indeed, the basic materials sector represents less than 3 per cent in both of Clark’s strategies, compared with a 7.6 per cent weight in the benchmark index.
“Although we have a position in Rio Tinto we are very much underweight this particular sector,” he explained. “The reason for this is that mining companies are very cyclical, very volatile and we do not see dividend visibility.”
“You can get situations where the dividend is cut or suspended, depending on market conditions; we are looking for dividends that grow consistently over time and certainly don’t get cut.”
The manager said some of its major overweight sectors had also underperformed in 2017, most notably the healthcare and utilities sectors.
However, the funds were struck by a number of stock-specific issues that have also affected several other UK equity income managers.
One of the biggest was Provident Financial, the sub-prime lender, which earlier this year announced the departure of its chief executive and would be scrapping dividends. It followed profit warnings as problems with collections in its home lending business emerged.
Clark said he had cut his holding in the company after the extent of the problems became apparent, having previously held a 1.7 per cent stake.
He said the initial investment thesis had been based on the fund’s reputation and strong dividends over time and the fact that it had emerged through the credit crisis in good shape.
Clark said the scale of the problem had been “completely unexpected” but was convinced that the management would be able to correct it over time.
Other high-profile UK equity income managers such as Neil Woodford and Invesco’s Mark Barnett were similarly caught unawares.
Performance of Provident Financial in 2017
Source: FE Analytics
Clark said he had reduced the position due to the scrapping of the expected dividend in October and a full-year payout for 2018, but did not think it would not affect the fund’s dividend flows.
Another stock that impacted the funds’ performance this year was AstraZeneca, which struggled after announcing the failure of lung cancer drug Mystic.
“The reason for holding AstraZeneca a longstanding holding of ours is that it has been in process to restore growth to business after number of significant drug patent expiries,” he said.
“At the same time, it’s commitment to the dividend through years of slow growth meant yield was 4 per cent; it was very much a stock which gave income but option on upside once products come through.”
Despite the failure of the drug for treatment in lung cancer, Mystic did pass other trials that would help generate revenues, Clark said.
“We can now expect from AstraZeneca that sales revenue will grow in 2018 for the first time since 2010,” he said. “The stock has come back to growth through the trough and I believe it still remains attractive with a 4 per cent dividend yield.”
Lastly, tobacco stocks were another area where the fund struggled, the manager said, prompting it to cut one holding, Altria, the parent company of Philip Morris.
Despite having reduced exposure to tobacco stocks or planning to for some time, Clark said news that the US Food and Drug Administration were to introduce limits on nicotine in cigarettes to non-addictive levels had an impact.
“Whatever that announcement really means, I think the effect of this over time will be to drive the move towards ‘vaping’ and reduced harm products in the tobacco sector,” he said.
“That may be a good thing because most of the big tobacco companies have a lot of reduced harm products and that may give them an extra leg of growth. But that isn’t clear at the moment.”
Despite the downturn in performance in 2017, Clark remained confident that the funds will prove resilient.
“We have had periods of performance blips before but they have always restored themselves and I think this will be the case again this time,” he explained.
“Many of our stocks that we hold, particularly in consumer staples and utilities, are at relative lows but the businesses are still generating good dividend growth and I think still have superior return characteristics which will come through in the second half of the year, probably.”
Indeed, Clark remained positive on UK domestic stocks generally despite some of the concerns over the impact of Brexit and the future trading arrangements with its dominant export market in the EU.
“UK GDP remains positive but UK domestic stocks don’t reflect that,” he said. “You get a situation where the All Share is on 14 times whereas a lot of these domestic stocks are significantly undervalued on multiples of 10-11 – and sometimes below 10 – in terms of P/E ratio and significantly high yields from the market.”
Some of the domestic names that he has added to include UK Reit British Land, retailer Halfords, car auction business BCA and the aforementioned miner Rio Tinto.
“I think it’s fair to say equities will remain a solid source of income and capital growth something I’ve believed for a long time,” he said.
“There’s no sign of any major stress on any of the large companies or any sign of a downturn in the slowish but nevertheless real economic growth that we see in the major centres of the world in Asia, US and continental Europe.
“I don’t see a big equity bear market on the horizon, I think it will continue to inch forward.”
Clark added: “I am confident that stocks we own will outperform over time because they are stocks with high return on capital.
“The quality stocks that are able to increase dividends are subject to short-term performance fluctuations which is something we’ve seen this year, but I think that will dissipate.”