3 High Income UK Stocks

Emma Wall: Hello and welcome to Morningstar. I am Emma Wall and here with today to give his three stock picks is Alastair Gunn, manager of the Jupiter High Income Fund.

Hello, Alastair.

Alastair Gunn: Good morning, Emma.

Wall: So what's your first stock for us today?

Gunn: Well, my first stock for you is a company called Galliford Try (GFRD). So, Galliford Try is a housebuilder and it is also a construction company. Now, I might add that I like the housebuilding sector at the moment, so a lot of the reasons why I like Galliford Try are reasons that I like the sector as a whole.

But the starting point for me is that this is a relatively cheap stock, it is trading on P/E of roundabout 10 times, it yields about 4.5% at the moment. It has got a very strong balance sheet. And I can see over the next two, three years that we are going to have good growth in earnings – consistently good double digit growth in earnings, but the payout ratio – the dividend is going to grow by a combined rate of at least 25% and potentially much more. And I can see in a three to four year period that this stock at today's price would be yielding nearly 10%.

So, that's a very attractive dividend relative to where we are with interest rates and so on and a significant premium to the equity market.

Now the reason why I think we're going to see that is we've had a significant under building in the U.K. We believe that there are now – there is now shortage of 1.4 million homes in the U.K. So there is no problem with demand. And the supply side is being eased up significantly by government initiatives to help get land through the planning process and the housebuilders are enjoying very high returns on their assets at the moment.

So, I think, we've set for a period of the next three to four years where housebuilders will deliver growth and strong dividend growth as well.

Wall: The market seems to be quite divided about housebuilders, although that 10% yield sounds extremely attractive given the current income environment. You mentioned government initiatives there to get land through. There's also been government initiatives on the buy side would help to buy – to help people to get in the housing market, which is then obviously built up house prices and we're in what some people are calling a bubble. If that bursts how much impact does that have on stocks like that?

Gunn: So, I think, the underlying issue here is the government doesn't want to see house price inflation take off. And clearly there is strong demand and a lack of supply at the moment, and that's why house prices are going up. So, the government needs to do more on the supply side to help stop that bubble from developing. And when you look beyond London, there certainly isn't a bubble. House prices are still well below 2007 levels. So, I think, we won't see interest rate rise as quickly, but we will see supply side initiatives and that's why I think that the housebuilders are part of the solution rather than the problem.

Wall: And what's your second stock?

Gunn: My second stock is a company called AMEC (AMEC), which is an oil services company. Again I think the valuation looks quite attractive. It has a fairly good record of capital allocation so it's been accelerating returns to shareholders through buybacks and through a well-covered dividend. And the reason I particularly like it at the moment is it's about to complete a major acquisition in the U.S. of another oil services company called Foster Wheeler (FWLT). And I think that this is not only an earnings-accretive transaction based on the kind of synergies the company has been talking about today, but there are major tax and revenue synergies that come from this transaction once it completes.

The company talk about its addressable market growing to three times the current level from this combination because this is such a good fit between the two businesses.

Wall: It's been quite a troubled sector though, hasn't it, oil and mining, over the last couple of years? How dependent on the oil price is this company?

Gunn: Well, obviously, I know high oil price helps the customer, which in this case are the big oil companies and the national oil companies to commission work, and we've seen some hiatus in commissioning activity more recently.

But the big problem for the oil companies is that if they don't keep commissioning new exploration activity, the rate at which their existing production starts to fall away is really quite extreme. We tend to see something like 8% to 9% per annum deterioration in the current production base.

So, if you just run the business based on cash flow dynamics and so on today, you'll very quickly have a much smaller business than you did a couple of years ago.

Wall: Alastair, what's your third stock?

Gunn: My third stock again has a kind of an M&A aspect to it. It's Imperial Tobacco (IMT). Imperial Tobacco is interesting for two reasons, actually. The first is that, it is heavily exposed to the Eurozone region, and because we've had high unemployment, recessionary-type conditions and we've also had governments placing very high increases on cigarette taxes over the last few years, we've seen the amount of tobacco consumed fall away quite sharply compared to prior periods.

And one of the reasons that that's happening is, we've seen a big growth in illicit trade. And I think what will happen over the next few years is the Eurozone economy gradually picks up and unemployment starts to fall away, as some of that illicit trade will be replaced, governments will crack down on it. We'll start to see more normal levels of tax increases being imposed on tobacco, and the volumes will start to recover. So that's the first aspect.

The second aspect is that Imperial has cherry-picked some of the assets from the proposed merger of Lorillard and Reynolds American, who are the number two and number three players in the U.S. And to allow that transaction to happen, effectively those two companies have had to allow a new number three player to emerge.

So, Imperial has gone or will go from having a roundabout 4% share of the U.S. market to about an 11% share after buying some of the assets of Lorillard.

Now, the U.S. market is also quite an attractive market to be exposed to because it has a very low average pricing compared to other international markets. And there is definitely scope for the profit pool to grow faster than other international profit pools at the moment. And clearly, U.S. is in recovery mode already.

Wall: And that stock also pays quite a nice yield, isn't it?

Gunn: It does.

Wall: Alastair, thank you very much.

Gunn: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.