Rathbone Income managers Carl Stick and Alan Dobbie are trimming stakes in the more ‘defensive’ businesses that make up more than half their £818m fund, wary of the risk of a rise in inflation sparking a ‘vicious rotation’ from these stocks into cyclical companies.
Like most UK equity income funds, Rathbone Income is down heavily since the turn of the year, having lost 22.1%, marginally narrower than the average 23.6% fall for funds in the Investment Association’s UK Equity Income sector though steeper than the FTSE All-Share’s 19.5% loss. Over three years the fund’s 16.4% loss lags the average 15.3% for funds in the sector and the FTSE All-Share’s 8.6% fall.
The coronavirus-induced sell-off in markets has been particularly hard on income funds that have found themselves on the end of wide ranging dividend cuts, suspensions, and cancellations.
Dobbie said it had been an ‘extraordinary period’ for dividend cuts, pointing to estimates by Link Group in its regular UK Dividend Monitor report that payouts could fall by between 27% and 51% this year.
Dobbie warned that would feed through to a fall in his fund’s dividend to investors, though he is hoping the drop will be at ‘the better end’ of the range predicted by Link for the UK stock market.
Stocks like consumer goods group Reckitt Benckiser (RB), the largest holding in the fund, were among the portfolio’s better performers as its Dettol, Nurofen, and Finish dishwasher products pushed up sales in the first quarter. Halfords (HFD), which has rallied 224% from March lows but still remains down since the turn of the year, is another.
The managers sold out of cruise ship operator Carnival (CCL), Frankie & Benny’s owner Restaurant Group (RTN) and logistics group Bunzl (BNZL) as the coronavirus outbreak struck.
‘They are all in different industries but they have all had their business model fundamentally challenged by the pandemic,’ said Dobbie. ‘We took the decision to exit all three.’
Dobbie added that Shell (RDSA) and BP (BP) were also a ‘drag on performance’ after oil fell into the ‘incredible situation of a simultaneous demand and supply shock’.
‘The other main negatives were financials – insurers and banks were weak largely on the back of declining interest rates and some specific issues with Hiscox (HSX),’ he said.
Wary of inflation risk
The managers are now focused on the potential risks presented by inflation. While the pace of price rises in the UK last month fell to its lowest level in over three years as the nationwide lockdown hammered demand, Dobbie and Stick are eyeing a potential rise in inflation driving by huge government and central bank stimulus launched amid the coronavirus crisis.
A third of the fund is held in the quality growth companies the managers call ‘compounders’, with a further quarter of the portfolio in ‘cash cow’ companies generating consistently high returns but not offering the same growth, such as tobacco stocks.
Dobbie said the ‘uncomfortable truth’ is that the ‘a good bit of the outperformance’ in quality growth businesses, which have enjoyed a 10-year bull run, is due to falling bond yields.
‘Our job is to survey the table, see where the chips lie, and look for mispriced risk,’ he said.
‘What we see is there are a lot of chips piled up on one side of the table… what if all the monetary and especially fiscal stimulus causes inflation and a rise in bond yields, and another vicious rotation away from long-duration assets like quality growth stocks into shorter duration value or cyclical stocks?
‘We need to do more to protect ourselves and have been reducing the weighting in some compounders to neutralise the risk’.
Dobbie and Stick have added to cyclical banks and house building stocks which have ‘to differing degrees remained out of favour’ since the global financial crisis.
They have added a ‘small holding’ in Royal Bank of Scotland (RBS) to the fund ‘given it has significantly improved its capital position and is a more robust bank than it was’ and to diversify away from the holding in Lloyds (LLOY), which is more exposed to unsecured lending such as credit cards and car finance.
‘To our minds, much of the bad news is priced into some of these stocks,’ said Dobbie. ‘Banks will have to take further provision for loans going bad over the coming quarters but trading books are much smaller than in the financial crisis… and capital requirements are three to four times higher than they were in 2006/07.’
The managers also trimmed holdings in housebuilders Bellway (BWY) and Berkeley (BKG) to take a new stake in Persimmon (PSN).
Dobbie admitted Persimmon has been a ‘habitual sinner’ in delivering poor quality housing but Stick added that is was a ‘general way of playing the housing market and a very liquid way to get added exposure to diversify risk’.