Markets have staged a remarkable recovery from the savage falls in March. At the time of writing, the FTSE All-Share Index is up almost 20% from its lows. While this is welcome after a period of troubling volatility, we believe that a cautious approach is still warranted, even as countries gradually return to normality.
Countries are slowly returning to a ‘new normal’, but a huge amount of uncertainty remains on the timing and shape of the economic recovery. There are signs that earnings and growth may recover by 2021, but GDP growth forecasts continue to be revised lower and economic activity is likely to remain subdued. While the stimulus packages put in place will support growth in the short-term, there are questions over the impact of their removal.
Much will depend on the future trajectory of the virus. There has been some resurgence even in countries that have handled the virus well, though in general those countries that tackled the virus earlier and with vigour have seen their economies recover more quickly.
Equally, even when the impact of the virus diminishes, there will be other considerations: a potentially fractious and uncertain US Presidential Election, continued weakening in US/China relations, an untidy Brexit. These are all, we believe, reasons for caution in the current environment.
However, how this caution should be reflected in a portfolio is another question. The virus outbreak has disrupted many investors’ view of what constitutes a defensive portfolio, particularly for income. Previously reliable dividend payers such as banks, mining and utilities have cut their dividends. Estimates from Link Asset Services suggest only around one-third of dividend payments are safe.
We have tried to increase the resilience of our portfolio in a number of ways: the first is by maintaining a quality bias across the portfolio. This has been useful in the pandemic, keeping us away from the difficult areas – some of our strongest relative performance has been as a result of the companies we didn’t own rather than those we did. To our mind, quality means strong balance sheets and good cash flow, which gives companies resilience at times of stress. While few could have predicted the virus outbreak, it is possible to build up a company’s defences.
Diversification is another defence. At the start of the crisis, it appeared that the virus would have its biggest impact in Asia, but that has been revised to Europe and then the Americas. Shires Income is a UK-based portfolio, but we ensure that the sources of revenue for companies in the portfolio come from across the world: as it stands, we have 20% from Asia Pacific, for example, another 27% from the Americas, 21% from Europe and just 28% from the UK.
This also applies to income. UK equity income funds are often criticised for relying on a handful of companies to deliver income. We consciously guard against this type of concentration. The FTSE All-Share Index (our benchmark index) generates around 35% of its income from its top five positions. In Shires Income it is just 20%.
Diversification also applies to a spread of assets. We hold large cap high yield equities, plus a number of growth equity positions (including smaller companies). Our 25%-30% weighting in preference shares is a reliable source of income and capital stability. This allows us to be flexible in other parts of the portfolio.
In terms of the companies we hold, we are looking for those with the ability to deliver growth independent of the macroeconomic outlook. This drives dividend growth over the longer-term and has to date included companies such as multinational cybersecurity software group Avast or outsourcing group Equiniti. In uncertain times, companies exposed to areas of structural growth will have a natural tailwind.
In an uncertain environment, some caution is needed on the price we pay for any new holdings in the portfolio. Valuations are already looking through to 2021 earnings and the recovery has been remarkably quick. We look for an attractive entry point. There are still opportunities across UK markets, which trade at a discount to their international peers, but careful stock-picking is needed.
As we see it, markets may have come through the easy part of the recovery and may not reflect the level of uncertainty that we believe still exists. Nevertheless, there is significant variation between individual sectors and companies. Active managers should be able to add real value in this environment.
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Ian Pyle is Investment Manager at Shires Income PLC.
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