The UK stock market is in schizophrenic mode with some stocks soaring and others slumping. For long-term investors there are sound reasons for buying now.
The shares that have taken the biggest pasting over the past year are financial stocks, especially the banks, which on average are down 20%. But many individual shares are down far more than that.
Though their share prices are higher than in the last bear market, banks’ profits have risen so much since then that many bank shares are actually cheaper than they have been for over 20 years.
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Markets can always fall another 100%
That doesn’t mean they can’t go down further - as the great economist Lord Keynes remarked, ‘Markets can stay irrational longer than you can stay solvent’. But on a five- or 10-year view, only the complete collapse of the financial system could prevent shares in the larger banks from rising substantially from current levels.
That explains why many of the most successful UK fund managers have been piling into bank shares over the past few months. It hasn’t done them any favours so far, as share prices have continued to fall and have damaged the short-term performance of their funds.
Indeed, as my table shows, the average UK Equity Income fund has done worse than the All-Share Index over all the periods shown. This reverses a trend that started in 2000, and between then and mid-2006 equity income funds were doing better than the market average. Of course many of our selected funds have done better than the sector average and indeed than the All-Share Index over the past three and five years. But the sector as a whole has been hammered by the poor performance of financial shares.
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* Including reinvested net income. Data to 3/1/2008. Source: Financial Express
Will divis be cut? Banks say no, investors fear yes
The reason is simple: UK Equity Income funds have to generate a higher initial income than you can get on the All-Share Index. So the managers look for shares paying high dividends and banks have always been one of the best divi-payers.
So most equity income funds have usually held a good slug of bank stocks. But recently, many managers have loaded up on even more. After all, the dividend yield on Barclays is 7.5% and on Royal Bank of Scotland it is 8%.
What those numbers tell us is that many investors fear that the banks will cut their dividends as a result of losses arising from the ‘credit crunch’ so that you won’t actually collect those big fat dividends.
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Panic not reason is in control
Yet on the information published by the banks so far, their exposure to potential loses is not sufficient to force them into dividend cuts. So investors are in the grip of one of those unreasoning panics that may well prove a golden buying opportunity.
Certainly many of the managers of our selected UK Equity Income funds think so. Toby Thompson at New Star now has a massive 47% of his fund in financial stocks while Scott McKenzie at Martin Currie has 30%, Anthony Nutt at Jupiter Income 25% and Carl Stick at Rathbone Income 24%.
Most of the others have about 20% in financials. Only two of our selected funds are steering clear of the sector: Invesco Perpetual Income and Neptune Income. Neil Woodford at Invesco Perpetual is probably the most successful UK equity income fund manager so the fact that he has just 7% of his £6 billion Income fund invested in financial stocks certainly has to make you stop and think.
Robin Geffen at Neptune has the highest portfolio turnover of any of the funds in our list, so the fact that he has only 9% in financials is less meaningful- he may already be changing his position.
On the other hand, other managers have gone on record as being buyers of financials, including the legendary Anthony Bolton of Fidelity.
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Buy the bombed-out and hang on
It’s not just banks that are bombed out. Housebuilding shares and shares in big real Estate Investment Trusts have been hammered. So have non-food retailers- in fact, the average fall in their share prices over the past year is nearly 25%.
In the past, UK Equity Income funds have tended to buy into these bombed-out sectors and stocks because of the big dividends on offer. And so long as you do sort the wheat from the chaff- weaker retailers like Woolworths might not survive- and hang in for a year or two, this ‘contrarian’ strategy is often very successful.
So at times like the present, UK Equity Income funds have some similarities with ‘Recovery’ funds. Except that UK Equity Income funds also tend to hold duller dividend-payers, and at present, Big Oil (BP and Shell), utilities and engineering companies fill this slot.
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Rising income target
UK Equity Income funds don’t just aim for a decent income today. They also aim to increase it faster than retail prices, so that investors get a growing real income. Over the years they have achieved that and in recent years divi growth has been at least 50% higher than the RPI.
Managers were beginning to worry that it was going to be hard to match that rate of growth over the next few years, but being able to buy bank, retailing and housebuilding stocks on the cheap means funds will probably be able to raise dividends by 6-8% in 2008.
Over the long term, rising dividends mean rising capital values too. After all, if those big banks really don’t have a major problem and don’t need to cut their dividends, their share prices need to rise by at least a third to bring them into their normal historical price range.
My top choices from our list of UK Equity Income funds right now are Artemis Income, New Star Higher Income, Martin Currie UK Equity Income and Rathbone Income. These are ideal ‘buy-and-hold’ investments for your retirement and for long-term regular savings plans.
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Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
