AA-rated UK income star: analysts are wrong on financials

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Euro Stars AA-rated duo James Lowen and Clive Beagles believe many investment analysts and managers are failing to take account of company debt when valuing companies.

The JOHCM UK Equity Income  managers also think many are overlooking the extent to which financial firms in particular are starting to grow their earnings and profit margins by moving into new areas that require relatively little capital expenditure.

The £1.5 billion fund has continued to prosper from a pronounced overweight to financials, with Lowen (pictured) arguing that many analysts are missing out on how many of these firms are transforming their business models to grow both profitability and dividends.

Plenty more upside for financials

Despite financials being the best performing sector in the FTSE last year, Lowen believes there is still plenty more upside to come for the sector as valuations had fallen to such a low base.

He told Citywire Global: ‘People are spending too much time on fundamentals and not enough on valuations.

The fund’s financials exposure is 12% ahead of the index, with a diverse range of financial services, specialist lenders, non-life and life insurers, and Lowen tips many of these stocks to become even more attractive as they move into what he terms asset light businesses.

Private equity investor 3i, and insurers RSA, Standard Life and Legal & General are all top 10 overweight positions while Aberdeen, Investec and Close Brothers are all key holdings.

The pair like these businesses because they are moving into areas that require relatively little capital expenditure.

Lowen said: ‘Standard Life used to be a traditional life business but it has grown its investment arm [SLI] and has a new platform business. We try to value these as distinct businesses but a lot of the market just looks at embedded value. People are only just starting to realise this with Standard Life.’

The managers added Investec in the last three months as they view it as an extremely fast growing business with a profitable banking and wealth management arm.

‘This company will soon be a FTSE 100 company and [perhaps due to its dual listing] it is only covered by one analyst. We are able to get access to a wealth manager but also to a bank at the cheapest possible valuation.’

A cheap entry point is crucial to the pair, who also operate a strict policy where every stock must yield more than the FTSE average, and any positions that fall below it are immediately sold.

The pair have been adding to their positions in Standard Life and L&G, as well as to specialist lender Intermediate Capital, but while they hold HSBC, they have a 4% underweight to banks as a whole.

They have also taken some profits on their media holdings although they still like the sector as they expect valuations to recover further.

‘ITV is on a price to earnings ratio of 10.5x, but if you adjust that to include its balance sheet it is on 8.5x because it is net cash.’

With strong balance sheets a crucial focus, Lowen says that around 20% of the fund’s holdings are sitting on net cash piles, with many looking to issue further share buybacks and return capital to investors.

‘Centrica issued a £500 million share buyback last week and we expect similar from Standard Life, Aberdeen and ITV.’

The group are ceasing to actively market the fund as it sits at just above £1.5 billion level, and Lowen is happy for the fund to remain around this size to keep it as a nimble alternative to many of its larger income rivals.

Last year we saw £400 million of inflows and £200 million out, as well as paying a £50 million dividend. We need enough flow to offset natural churn and with enough flow from platforms we are taking out the supra normal growth.’

Another key differentiator to many of its equity income peers is a complete absence of, or strong underweight to key sectors such as miners, pharma and tobacco stocks.

The pair have argued for some time that tobacco stocks are facing structural headwinds that will see volume growth and subsequently dividends come under pressure.

Lowen is ‘encouraged’ further in this view by last week’s profit warning from Imperial tobacco.

‘Imperial tobacco warned last week on its second year running of negative volume growth and they also have a lot of debt and regulatory pressures.’

The fund is also staying clear of beverages with nothing in drinks giant Diageo which Lowen describes as being on a ‘very full valuation’ at 19 x 2013 earnings.

The fund, which uses no derivatives, grew its dividend by 10.3% last year and Lowen says it is on course to deliver ‘more than 5% again’ in 2013.

Over five years to the end of January, the fund has returned 77.2% compared to 25% by the FTSE 350 Higher Yield TR index.