The manager of our UK Equity Income strategy explains why investors need to change their mindsets about what to pay for growth and cautions against buying yield for its own sake.

Read this article to understand:

  • The current state of the UK equity market
  • The outlook for UK dividends in the face of high inflation
  • Where the most attractive opportunities lie

In 2020, as UK businesses roiled from a global pandemic, dividends were one of the first things to be hit as companies adapted to the uncertain economic and trading environment. From a record high of £112.8 billion in 2019, dividend pay-outs slumped by almost 43 per cent in 2020, to £64.4 billion.1

While they recovered to reach £92.3 billion in 2021, investors hoping for smooth sailing in 2022 have been rocked by another unforeseen event: the Ukraine-Russia war, which has turbo-charged inflation and further disrupted already fragile supply chains.

To help us make sense of this challenging market, AIQ talked to the manager of the Aviva Investors UK Listed Equity Income Fund, Chris Murphy, who explained why many investors are still adjusting to the shifting macro regime.

How do you assess the current state of the UK market?

First of all, we can't ignore what is going on in the world. We have come through lockdowns, which created supply chain issues for nearly all companies, and China’s zero COVID policy has added to the pressure. There are also global shortages in labour markets. A year ago, most companies were slowly working through these problems, but now we have to overlay the Ukraine-Russia conflict on top of everything else.

Global crises tend to be sparked by the shock no-one sees coming

Global crises tend to be sparked by the shock no-one sees coming. And while I don’t think we are at that point yet, a prolonged period with these conditions could push us into one. Ukraine-Russia is disrupting supply chains further, causing huge inflation – especially in food and energy – and no-one can definitively say how long this will last.

This uncertainty is weighing on all markets and the UK is not immune. At this stage, most companies are navigating inflation reasonably well because they have been able to pass on rising costs to their customers, so margins have been protected. However, you have to expect some level of demand destruction due to fuel and food inflation; that has to impact the consumer in the end. 

If we put commodities to one side because they distort markets, good companies around the world have seen valuations fall significantly – many of whom were not trading on huge growth multiples either. That means some of this uncertainty is discounted, but I’m not sure we have seen a full adjustment globally. In the UK, there is at least some comfort that companies were trading at discounts relative to their peers elsewhere, despite returns on capital and balance sheets that were as good if not better. There are still opportunities to invest in UK businesses at the right price.

If you take a longer-term view on fundamentals, there are also attractive stocks – dividend paying ones – further down the market cap scale.

Despite the sell-off we have seen in equities in 2022, are growth stocks still expensive?

I think growth is still overvalued everywhere. If you look at NASDAQ, it has collapsed – many of these tech companies were trading at the wrong price because their valuations accelerated when money was free. Globally, there has to be an unwind of people's mindsets on what you pay for growth.

The UK market has really benefitted from the high relative weighting to oil and mining

In contrast, the structure of the UK market is different, and this year it has really benefitted from the high relative weighting to oil and mining. The one area investors need to be really careful on is the mining sector. Whenever you get a period like this where commodity prices are high, investors get overexcited. However, the big players in the sector are capital and labour intensive, so they will get squeezed by inflation. 

Dividends in the UK suffered hugely during COVID-19 – to what extent have they recovered?

In some respects, what we saw through lockdowns has put dividend stocks on more of a solid footing. Companies have recovered their dividend and managed them sensibly against their balance sheets. Clearly, that is attractive for a lot of investors in the current environment who are wondering how they are going to achieve their total return targets if growth underperforms. Reinvesting your dividend payments or taking them out will be a big chunk of that total return.

At the same time, you can’t go out and buy yield for its own sake. We are just coming out of a huge bubble that dates back to the post-financial crisis period. These sorts of regime shifts take a while for people to adjust to. The only thing we can say with any degree of confidence is the next ten years – in terms of the macro picture, interest rates, inflation and valuations – will not be the same as the last ten.

Having a disciplined focus on investing in companies that generate reliable cash is particularly attractive in times of uncertainty and rising interest rates.

Investors will look for income to protect against inflation. Are certain parts of the market likely to cut dividends?

I’ve done a number of events and client calls recently and the question everyone asks is “What do you think dividend growth will be?” This time last year, we were emerging from the pandemic and companies were looking at growth and reinvesting back in the business. In stark contrast, inflation is now soaring and a war has broken out.

Companies won’t try to keep up with inflation – nothing can keep up with ten per cent inflation

If I put myself into the shoes of a company executive going into a board meeting, even if the last six months' results are reasonable, you are likely to be more cautious on dividend growth. I still think they will grow overall, but they might be tempered slightly. Companies won’t try to keep up with inflation – nothing can keep up with ten per cent inflation.

In terms of my portfolio, it is important to be patient, have conviction in the companies we are buying and think carefully about who is more likely to do well in an inflationary environment. One of my big holdings is BAE Systems; we are in a volatile geopolitical environment where defence companies are going to be in demand. This is the kind of business able to pass costs on to its customers, grow in absolute terms and grow dividends through this.

Where else are you seeing opportunities?

This might sound a bit boring, but it is the businesses I have owned for a while, like Greencoat UK Wind, which runs wind turbines. In a world of higher energy prices, we want to drive people towards greener energy, which will support the valuations of these types of businesses. In the past year, I have added to SSE, which operates a portfolio of hydroelectric power plants. Irrespective of the macro picture, these companies are going to be consistent and continue to deliver.

One interesting holding is in Hipgnosis, which buys music rights to songs or back catalogues, while trying to improve royalties for the artists. There is a sea change going on in the industry, and Hipgnosis has an interesting model that should be on the right side of regulatory change.

As for adding anything new to the portfolio, while the valuation of pretty much everything apart from oil has fallen recently, you have to think carefully about how you will fund it. When acquiring new names, it makes sense to err towards more defensive stocks that aren’t so sensitive to the economic environment. How the consumer behaves is going to be the big thing later this year. If this leads to retail companies reporting disappointing numbers and that hits share prices, it could present some opportunities – but we need to wait and see.

There’s been a backlash recently against ESG in some quarters. Are you sensing any weakening commitment to ESG issues as company management prioritise short-term financial concerns?

I don’t sense any weakening in their commitment; I think they are probably just fed up with always being asked about it! Businesses take time to change and want to be left to get on with it.

Businesses take time to change and want to be left to get on with it

One of the interesting things about a lot of ESG funds – and they weren’t alone in this – is that over the past few years they were buying certain stocks at very high multiples and have suffered as we have seen an unwind of those valuations. It is important to note that the overwhelming majority of funds out there don’t have an ESG label but will have a much bigger impact in terms of how they are positioning for the transition and in turning brown stocks to green.

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