Lipper’s Jake Moeller reviews highlights of a meeting with Jack Barrat, Assistant Portfolio Manager, GLG UK Income Fund, on August 4, 2015.
Equities have been a major beneficiary of investors’ appetite for yield in a low-rate world. Flows into equity income funds have been especially buoyant and show few signs of abating. Indeed, the U.K. equity space is awash with a number of large income-focussed funds, many sharing a high degree of stock commonality across their portfolios.
It is with this background that meeting Jack Barrat of GLG proved a considerably refreshing experience from a fund analyst’s perspective. GLG recently decided to reboot its U.K. equity income proposition, handing the management of this fund over from John White to the co-managers of the GLG Undervalued Assets (UVA) fund: Henry Dixon and Mr. Barrat. They have now been managing the equity income fund for 18 months in addition to their UVA portfolio and have reshaped their new fund considerably and quickly. “Managing U.K. equity income wasn’t an intuitive fit for us,” concedes Mr. Barrat. “Henry and I had to think long and hard about whether we wanted to take this portfolio on–we have never thought that selecting stocks simply with a high dividend yield is a recipe for outperformance.”
Fully committed to their existing process, the yield demands of the UK Equity Income sector classification initially presented a “constraint”–alpha generation had always held primacy. As it transpires, the solution for the pair was indeed inherent in their existing methods, requiring only the addition of a handful of ancillary processes, rather than invention of an entirely new analytical system.
The key appears to not be hung up about the 110% IA requirement per se and the creation of three stock “buckets.” The first bucket is their existing methodology, with an added “dividend yield greater than market yield” condition (currently 73% of the portfolio strategy). The second bucket allows the managers the flexibility to include stocks holding “significant net cash with possibility of cash returns.”
Thus, a stock with “a dividend yield that is at least half that of the market, growing at least twice the market rate” could be considered (currently 22% of the strategy). The third bucket of “capital structure opportunities” allows modest exposure to mezzanine debt (mainly convertible shares) to boost portfolio yield, where the managers are comfortable that prudent debt restructure has made the equity more palatable (currently 5% of the strategy).
Table 1. Eighteen Month Performance of GLG U.K. Income v Peer Group and Benchmark (since new management in GBP)
Source: Lipper for Investment Management
The initial stock selection process is unchanged from that of the UVA fund, with enterprise value/invested capital and ROIC/WACC being the main screening metrics. Mr. Barrat also emphasises their UVA mantra of an “exceptionally” strong balance sheet and management team members who are “fantastic custodians of capital” as a key foundation to the adaptability of their process for income. Indeed, Mr. Barrat is confident enough to declare little fear of dividend cuts. “If dividend cuts are a right thing for a business to do, we respect this,” he states. “We don't want to hold something yielding 6% that was at 3% and where the market has got more nervous on their ability to pay until that reality occurs!” He cites a recent example of Admiral, which “prudently” cut its dividend 1% to little market fanfare.
Mr. Barrat is very quick to draw attention to what he sees as a misconception on dividend payments somehow being indicative of a “quality” business. “Look at Pepsi between 1973 and 1980,” he states. “[It was] cash generative, a good brand, a consumer staple, growing earnings 20% compounded over these five years with a good ROIC, yet the shares over the period went down 7%!”
This is the distinction GLG makes between “quality” and “value,” where many income funds hold dividend stocks on high multiples not backed with a good deal of cash and susceptible to de-rating. Mr. Barrat provides the example in Table 1. below, where his process would lead him to prefer QinetiQ over Severn Trent, despite its higher payout ratio:
Table 2 Distortion Through the Dividend Lens...
Source: GLG Man. Note these figures applicable at the time of the initiation of positions in early 2015
Mr. Barrat shared with me the concern that income investing is very much “in vogue,” causing congestion in the U.K. equity income space. He is also cautious about the outlook for U.K. equities generally. “Everybody is crowding into similar space,” he states, “and we are nearer the top of the cycle than the bottom, with four straight years of rising markets and falling earnings in the U.K. We deliver durable yield in much less crowded areas of the market.”
Indeed, a cursory glance at the fund’s composition reveals it to be considerably different to many of its peers. There is little exposure to large pharmaceutical and tobacco stocks and a notable omission of some big names such as Royal Dutch Shell. The lack of the larger “bond proxies” is intentional, and the fund has a slight mid-cap bias to it that isn’t threatened by imminent capacity issues. The prudent use of a small amount of mezzanine debt appears appropriate within the context of the GLG methodology.
Table 3. Three Year Lipper Leader Scores - GLG UK Income (to June 2015)
Source: Lipper for Investment Management
The performance of the fund under the new management has been first quartile and has been maintained with a strong running yield. The turnaround in the 3 year Lipper Leader ratings as a result of the turnaround (see Table 3, above) has been remarkable. The fund currently sits in the U.K. All Companies Sector, more by virtue of the reconstruction of the portfolio than any reticence of the fund managers to willingly adhere to the IA parameters. “It is our intention to get into the IA sector as soon as the three-year requirement is met,” affirms Mr. Barrat, and the shorter-term annualized rate since the duo assumed responsibility is well above the IA requirement.
Despite not having the requisite three-year track record here that some gatekeepers require, the fund certainly offers the potential to diversify style bias within a fund-of-funds construct. Messrs. Dixon and Barrat are highly impressive fund managers who have managed to bring some refreshing insights and a unique methodology into a crowded U.K. equity income space.