New perspectives for income hunters

UK stock markets offer plenty for shrewd income seekers. Iain Pyle, manager of Shires Income investment trust, talks incoming tail winds, evolving energy firms and looking beyond the FTSE 100.

The UK market has lagged its global peers since 2016, falling to a historic relative discount. But with interest rates looking set to rise that could soon change, according to Iain Pyle, manager of abrdn’s Shires Income investment trust.

With the FTSE 350 now at a roughly 35% discount to the MSCI World – the largest disparity in three decades – the reasons behind this relative underperformance remain unclear. ‘The derating began with the Brexit vote in 2016, but the negative implications of that event should now be priced in,’ Pyle said.

The fact that the UK market is relatively underweight in terms of exposure to high-growth companies – most notably the Faang giants (Facebook, Amazon, Apple, Netflix and Google) – has certainly been another reason for underperformance, but the recent rotation into value at the expense of growth could be the start of a sea change, he added.

With a rate rise cycle now all but inevitable, rising bond yields should see the 10-year market dominance of high-multiple, high-growth stocks coming to an end, Pyle said. ‘We should get a much more balanced market and that would put the UK on a more even footing with other markets. The Brexit question remains, but the effects are now pretty well understood by analysts and companies, so earnings estimates should be factoring those in. Given all of this, the market’s derating on a multiple basis no longer seems to make sense,’ he said.

At the same time, the market’s high exposure to the energy and financial sectors, which have been headwinds in recent years, could now become tailwinds. ‘These are two sectors that could do well in a rising interest rate environment, and energy, in particular, is in a much better place than it has been for many years thanks to the rise in commodity prices,’ Pyle said.

The recent underperformance of the energy sector has left multiples depressed. ‘This is a value-oriented, low-growth sector which has been out of fashion; added to that, the last two or three years have seen ESG [environmental, social and governance] factors working against it,’ he added.

A new approach to energy

However, companies in the sector are working to improve both fundamental performance and sustainability issues, Pyle said. ‘All of the energy companies we talk to are developing their transition plans both to lower carbon outputs and to increase their involvement in the more growth-oriented parts of the energy market. At the same time, I think there’s a growing acceptance from the investor community that these companies need to be part of the climate solution going forwards and so divestment is not the answer. It’s much more constructive to engage and encourage them to do the right things. This is certainly the view that we take.’

Pyle looks for companies that offer reasonable income – in line with Shires’ income-generating remit – and have either a good transition story or a clear ability to benefit the environment.

A good example, held within Shires Income, is FTSE 250-listed Diversified Energy, which buys up mature gas wells in the US and aims to operate them in a more efficient and environmentally-friendly way. ‘Gas is not perceived in the same way as coal and oil, and will certainly be part of the global energy mix for years to come. We are happy to invest in a company with a compelling valuation and which we can clearly see is making a difference. If Diversified was not there, those gas wells would almost certainly be operated by private companies out to maximise short-term profits who would most likely not care in the same way about environmental impact,’ he said.

Pyle also notes the stock’s income-generating abilities, it currently has a 12% dividend yield, along with a 30% free cashflow yield.

A recent purchase is Wood Group, historically an oil services company but which now is increasingly targeted towards infrastructure, built environment consultancy, hydrogen technology and carbon capture. ‘These are areas that have a much longer duration than pure oil and gas services. It’s a company that is still being valued as if it is a pure oil and gas service company, but we see a really credible transition story,’ Pyle said.

Shires’ ability to look beyond the FTSE 100 also gives the portfolio exposure to mid-cap companies that are earlier in their growth lifecycle than many of the holdings commonly seen in a large-cap-focused income portfolio. Pyle points to Morgan Sindall and Telecom Plus as examples of exciting mid-cap opportunities. ‘One of the advantages of investing in the UK is that you have really good visibility for these companies. Because of the nature of capital markets in London, access to mid-cap companies is excellent, the coverage they get from analysts and brokers is strong, and company management is very willing to engage with us as investors. So finding good mid-cap ideas and getting them into the portfolio is definitely easier than it is elsewhere,’ he said.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

This article was written and originally published by Citywire Investment Trust Insider.

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