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Amid the UK gloom there are bright spots, says Schroders’ Noffke

19 March 2018

Sue Noffke, manager of the Schroder Income Growth trust, highlights three UK consumer companies she believes are attractively valued for the yield they are offering.

By Rob Langston,

News editor, FE Trustnet

UK stocks with exposure to the domestic consumer look attractively valued despite the lack of clarity over ongoing Brexit negotiations and what impact they might have on the economy, according to Schroders manager Sue Noffke.

Noffke, who manages the £191.6m Schroder Income Growth investment trust, noted that Brexit negotiations have prompted significant concerns over UK equities among global investors.

“Uncertainty about the country’s long-term relationship with the EU, its biggest trading partner, has left many international investors nervous,” she said.

Indeed, as the below chart shows, the most recent Bank of America Merrill Lynch Global Fund Manager Survey revealed that 36 per cent of managers had a net underweight UK equity exposure, close to post-global financial crisis-era lows.

 
Source: BofA ML Global Fund Manager Survey

Since the referendum, the MSCI World index has risen by 31.07 per cent compared with an increase of 18.17 per cent return for the FTSE All Share index to 18 March, in local currency terms.

However, UK equity income manager Noffke said she disagreed with her peers, arguing that negativity towards the UK was overdone.

She explained: “I can see bright spots in the UK stock market that offer a decent balance of risk and reward – and contrarian though this might seem given all the recent gloom about the pressure on household spending, some of the most attractive opportunities are among companies that focus on the domestic consumer.”

Noffke said there were a couple of reasons that negativity towards the UK has been overdone, adding that concern over the impact of Brexit may already be priced into the market.

“In share price terms, domestic companies started to underperform internationally-focused UK companies in early 2016, as the EU referendum drew closer, and that trend strengthened after the vote,” she said.

“But since last November, the political background has grown a bit less discouraging and domestically focused shares have stabilised.”

Another reason that Noffke is more bullish than her global peers is that the UK does not appear to be heading for recession in the foreseeable future.


 

“We have seen upward revisions to the economic growth figures, which are now running at closer to 2 per cent a year than 1.5 per cent – not brilliant, but certainly not disastrous,” said the Schroder Income & Growth manager.

“Similarly, the pound is stronger than it was after the referendum. Sterling’s slide – which pushed up the price of imports and therefore the rate of inflation – was a big part of the reason why shares in domestically-focused UK companies fell so far out of favour.

“Now a slightly stronger pound is helping to damp price rises and make imports more affordable.”

UK CPI inflation over 10yrs

 
Source: Office for National Statistics

Noffke added: “I believe inflation is near its peak and that, coupled with strong employment and reasonable wage growth, will be enough to start easing the squeeze on UK household spending.

“Companies that serve the UK consumer should be among the main beneficiaries of that trend.”

However, she said while valuations suggest she is in a minority of managers, for investors taking a view of two-to-three years it might be “a good time” to buy high-quality domestic companies.

“Their shares are trading at their biggest discount to UK exporters in almost a decade and are near their widest discount to the overall UK stock market since the financial crisis of 2008-09,” the manager explained.

She said there were three consumer-facing companies, each with a strong investment case, that were cheap on valuation measures such as price-to-earnings multiples and dividend yields: Tesco, Pets At Home and Hollywood Bowl.

Noffke said she expected Tesco to rebuild profit margins towards a target of above 3.5 per cent in the next two years following a challenging time for the UK’s largest supermarket chain.

“It is also rebuilding its position with customers and gaining market share, according to the latest supermarket industry sales data,” she said.

“Couple those factors with gradually rising interest rates and bond yields, which should help to reduce the size of Tesco’s pension deficit, and we believe that over the next couple of years the company should have significantly more cash available to invest in its operations and distribute as dividends to shareholders.”


Pets At Home, meanwhile, currently has a dividend yield of 4 per cent and has been growing its position in services, with more than half of its 700 stores now including veterinary practices and grooming parlours.

“These increase footfall for the stores and they also earn very attractive returns in their own right,” the Schroder Income Growth manager explained.

“We believe they should command a premium valuation, but our analysis suggests the current share price does not reflect the long-term value of these in-store services.”

Finally, Hollywood Bowl – a nationwide tenpin bowling alley operator – is a smaller company which Noffke said has “invested steadily in improving its customer experience while emphasising value for money”.

She said: “The food and drinks offer is better and they’re trying ways to give users more plays in their time slot.

“It’s a growing business that generates a lot of cash and has a dividend yield of just under 4 per cent, which the management has supplemented with special dividends. We think there will be scope to do this again in future.”

Noffke added: “These are three cases where we were able to invest in strong businesses with an improving outlook at a price that we feel tilted the odds in our favour.

“Amid the gloom about UK shares, there are bright spots if you know where to look.”

 

Noffke has managed the Schroder Income Growth trust since mid-2011. It aims to provide real growth of income in excess of the rate of inflation and capital growth “as a consequence of the rising income”.

Performance of trust vs sector & benchmark over 3yrs

 
Source: FE Analytics

Over three years the trust has delivered a total return of 16.78 per cent per cent compared with a 20.08 per cent gain for the FTSE All Share index benchmark and an 18.74 per cent return for the average IT UK Equity Income peer. During that time, the trust would have delivered income of £120.65 on an initial investment of £1,000.

Schroder Income Growth is currently trading at a discount of 7.7 per cent, is 5 per cent geared, a dividend yield of 4.2 per cent and ongoing charges of 0.95 per cent, according to data from the Association of Investment Companies (AIC).

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