Emma Wall: Hello and welcome to the Morningstar Series, 3 Stock Picks. I am Emma Wall and I am joined today by Matt Hudson, Manager of the Schroder UK Alpha Income Fund.
Hi, Matt.
Matt Hudson: Hi.
Wall: So what's the first stock today?
Hudson: Well, a stock that we have a lot of interest in is Lloyds Banking Group. It's a business that most of us will be familiar with, it's a big player in the mortgage market and also into lending and helping SMEs [Small & Medium Enterprises] develop their businesses.
It is a bank that's been under pressure from the financial crisis. But we're starting to see the benefits of the restructuring that they've undertaken coming through. It's a business that's producing a lot more capital than it has done historically and that is feeding through into dividends and dividend growth.
So two years ago the stock had zero yield, now it's trading a small yield discount. But over the next couple of years, we expect dividends to be able to substantially increase; and for this stock, Lloyds Banking Group, to be another high yielding asset within the market.
Wall: I think a lot of investors are still very nervous about the financial sector and preferring perhaps to go into insurers or into these challenger banks. Lloyds, of course, is one of the incumbents and has been through the mill. What do you say to people who are still nervous about the big banks?
Hudson: Well, we still feel that there are clearly some risks out there. But the core banks, the larger ones in the bigger markets such as the mortgage market, they are still very successful businesses, they are capable of producing a lot of supernormal capital, which potentially can be paid out to investors.
We've really been in this period where the downside scenarios, the risks around previous conduct of business have been in the forefront of investor's minds. And now, I think, we are coming towards the end of that. And what Lloyds have done is successfully focused the business on their core markets, where they've got good market positions and are returning, hopefully, surplus capital to investors by way of dividend and we always like that.
Wall: And what's the second stock today then?
Hudson: The second stock is Vodafone. It's a stock that's been a good call for us over the last six months or so; a company that again like many others went through some difficult periods, particularly with the exposure to Europe.
But what we're beginning to see is the monetisation of data, whether it's 3G or 4G you are beginning to see consumers desiring to have better service, and recognising that to get that sometimes that you have to pay for better capacity. And that's really one of the positives that we see coming through in Vodafone, and I think for the whole telecoms industry in Europe as well.
Europe is a bigger market for Vodafone. It's been a difficult place to be exposed to, particularly think of some of the southern European markets. But even those are beginning to improve.
So what we see is a business that's been able to drive better returns for shareholders; that has been investing in making their business more enabled for a 4G world, and that's really starting to come through in the rate of revenue. Revenues were negative last couple of years, now they are going positive. And that's a really important inflection point for the stock.
Wall: Vodafone I think was the biggest dividend payer in 2014. Thanks to quite a high dividend yield plus on top of that the special divi from the Verizon deal. I mean it was great to hold last year, what's to say that that sort of thing is sustainable. Obviously, the special divi was a one-off, but just that high yield?
Hudson: Well, I agree the special dividend is a one-off, but we think there might be some more potential capital-oriented M&A opportunities around the business over time as we see this convergence between media, telecoms and technology, and that continues.
So at the moment the dividend is not fully covered by cash, but the business is able to maintain its dividend because of the cash it got from selling the US assets and we saw that really at very good time.
So where that cash is being redeployed is into new networks and into improving the service. So over time we should start to see the business being able to cover that dividend and potentially continue to grow over time, not perhaps as much as some other things we can find, but certainly it's got a very attractive dividend yield and potential to maintain that in real terms.
Wall: And what's the third and final stock today?
Hudson: The third stock is Travis Perkins. It's a stock we've been building a position in over the last 12 months or so. It may be familiar to some of you: big green lorries driving around the place. So a business that is a builders merchants to the trade, it also owns other businesses in the retail area including things like Wickes.
So it's a company exposed to the slow recovery in the UK economy whether that's residential or commercial. But more importantly, it's a business with a lot of self-help. There are a lot of parts of the business where cash flow returns can be improved, where pricing the underlying products can also enhance profitability. And although the stock is only yielding about 2.3%, say, some way below market, we see a much better progression for dividend growth in the mid-teens over the next couple of years as those self-help stories start to come through, as the cash comes through and the balance sheet gets stronger.
Wall: This government, in particular this Chancellor, George Osborne, is being incredibly supportive of the housing market, the DIY market. How sustainable is that, because that was part of his recovery story—the thing that was getting the UK back to growth—now that we're sort of on a more even-keel, do those companies sort of lose momentum?
Hudson: I think from the perspective of their volume, which is really important for a builders merchants, it's not the price of houses, it's the volume that's being built. That is still at a very low level relative to any normal period you'd expect to see. So, actually, I think there is some more upside to come from that.
But importantly for a business like Travis Perkins because these exposures are, yes to the residential side, but also to more commercial, to more infrastructure those projects are only just really starting. We talked to a lot of companies who are at the smaller end, who are really seeing a pick-up in activity across the country and really it's playing into that slow recovery.
Now maybe it won't be as fast as it was in the last cycle, but certainly a more sustainable top-line level of growth. And as I say, with the better self-help that this business has got then, we'd expect what could be sort of a mid-single-digit top-line to translate into much stronger levels of earnings and, importantly, dividend growth.
Wall: Matt, thank you very much.
Hudson: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
