This article is part of Morningstar’s Guide to Income Investing. Whether you are looking grow your pension pot, or invest for retirement income, this week we have all the news, information and education you need.
Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined today by Mark Wharrier, Manager of the BlackRock U.K. Income Fund to give his three stock picks.
Hi, Mark.
Mark Wharrier: Good morning.
Wall: So what is the first company today?
Wharrier: Well, the bank sector we think is very interesting at the moment and it's an area we've been increasing in the portfolio this year. The company Lloyds (LLOY) has been a share that we focused on. I think the sector is interesting because you've gone through this horrendous period of bad debt write-offs, PPI, insurance claims. That’s now coming to an end.
So essentially in a bank like Lloyds you have very cash generative, very strong deposit taking franchise. The cash flow that it's now going to be generating is going to be able to be distributed to shareholders. Also the regulatory environment is, well it's not great it's becoming less bad and that’s important for a share that trades on a pretty low P/E multiple and a pretty low price to EBIT multiple.
Wall: You say things like PPI are coming to an end. But I was listening to the radio morning and they were saying that even more fines are expected. Do you think it's just a drop in the ocean for these banks now and actually even if there are further fines actually it's not going to affect things like the dividend?
Wharrier: I think it's just really the scale of the liabilities that we are looking at going forward – five years ago we were looking at multi-billion pound liabilities. And I think the fines and those types of conduit costs they can be accommodated in business as usual expenditure. So I think that’s the key change and companies consequently got more visibility in terms of how much capital that they can now distribute to shareholders.
Wall: And what's the second company today.
Wharrier: Well, it’s a company we've held for a long time is Next (NXT), which is, I'm sure, a familiar company to everybody who invests and everybody who shops. But I think it’s a great example of a company that's operating in quite a difficult environment, the U.K. clothing market is not without its challenges, but because the company has a very low cost base it's been on the forefront of growing its online business directory.
It’s a very high return and capital business. What's turned a good investment into a spectacular investment is what the company has done with that cash flow and what it's done with its balance sheet.
So if you go back to the year 2000 the company's returned over £3 billion in share buybacks over that period. So an earnings growth that perhaps running at 5% or 10% has been running strong double digit because they have shrunk the share count. They have been very disciplined with capital and they have rewarded shareholders rather than through diversification or over expansion. So a company really focused on shareholders and that’s what we like to see.
Wall: So many retailers have fallen foul of ecommerce but Next seems to get it right. You've mentioned you've held it for some time, is Next a sort of stock that you could go on holding for ever and ever – sell trigger with that sort of company.
Wharrier: Obviously if it became very expensive. If the P/E multiple started to go into the 20s we would reexamine it. But at the moment it is still trading on free cash flow yield which is the metric we really look at of about 5% and for a company with such a great long term record and dividend yield is still very attractive. We think it still stacks up.
Wall: And what's the third and final company today.
Wharrier: Well, it’s a company we bought last year, Carnival (CCL) which is a cruise line operator. A slightly more controversial holding, this has been a poor investment really for the last decade. The company has had a lot of self-inflicted problems. But when new management team took over last year and we think they are gradually turning it around, but like a cruise ship it takes a long time to turnaround. But if you look at the airline industry and if you book a flight with EasyJet, the flight tends to become more expensive as you get towards the departure date.
The cruise industry hasn’t worked like that for the last couple of decades. There's been too much stock that’s been left to sell at low price at the last minute.
What management are doing now is starting to change that mentality. So better yield management more facilities for better onboard spend. For a company that’s trading close to book value. There is lot of gearing there in terms of share price performance if the management pull off that restructuring.
Wall: And how reliant is that company on the U.K. economy because obviously it's more pounds in the pocket for the consumer means more pounds to spend on things like cruises. Obviously we are in quite comfortable place in the U.K. economy, but interest rates could change that it could mean less money in the pocket for individuals because they are going to spend more on their mortgages. Are you keeping an eye on that?
Wharrier: It's a good point and I think all consumer companies we need to think about this because we are now in a quite mature phase for the U.K. economy. The great thing about Carnival and the cruise industry is this really the grey pound that drives that industry and actually rising interest rates for many pensioners means higher income to more discretionary spending power. So it's one of those few consumer players that could actually benefit if the interest rate environment changes.
Wall: Mark thank you very much.
Wharrier: Thank you.
Wall: This is Emma Wall from Morningstar. Thank you for watching.
