2017 proved a challenging year for UK equity income funds, leading to some investors selling up. Outflows from the sector totalled more than £3.5 billion last year.
But the sector still holds a considerable amount of your cash – 6% of all money invested, equalling more than £60 billion. Add to that the funds in the All Companies sector, where several income funds have been booted out too after failing to meet the yield requirements of the Investment Association, which have an incredible £161 billion in assets under management.
Conclusion? Home grown stocks are popular. Even more so if they can pay a dividend. Despite the Bank of England raising interest rates in November for the first time in a decade, cash savings accounts still do not deliver an attractive rate of return.
The forecast for 2018 does not look particularly rosy either. Rises in the Bank rate are to be low and slow, if Governor Mark Carney is to be believed, despite inflation running at the highest level since March 2012. And so the hunt for yield will continue.
But the backdrop has changed. Unlike nine years ago, when the Bank of England first cut rates to a record low of 0.5%, the stock market is not in the doldrums. The expected returns from global equities are reduced – as Morningstar Investment Management’s Dan Kemp says: “The overall opportunity set has become considerably less appealing as we enter 2018 than this time two years ago. This is typical of a bull market, where expensive valuations lift all boats and commensurately push down our reasoned expectations.”
Finding stocks which are undervalued – often an indication of market headwinds – and yet still able to pay a dividend is no mean feat, but there are a few stocks to choose from.
Where are the Professionals Investing?
We can identify UK equity income fund managers’ favourite 10 stocks by looking at the overlap between their portfolios. Using the X-Ray tool on Morningstar.co.uk’s Portfolio Manager we can see the stocks held in common between UK equity income funds from Liontrust, Artemis, Schroders, Fidelity, Invesco Perpetual, Standard Life, Threadneedle, Neptune and Rathbones.
Their aggregate top 10 holdings are GlaxoSmithKline (GSK), BP (BP.) and AstraZeneca (AZN), HSBC (HSBA), Royal Dutch Shell (RDSB), British American Tobacco (BATS), Imperial Brands (IMB), Legal & General (LGEN), Aviva (AV.) and Vodafone (VOD). Of these 10, three are considered undervalued by Morningstar equity analysts.
3 Undervalued Income Stocks
GlaxoSmithKline
As one of the largest pharmaceutical companies, GlaxoSmithKline has used its vast resources to create the next generation of healthcare treatments. The company's innovative new product line-up and expansive list of patent-protected drugs create a wide economic moat, in equity analysts’ opinion.
The magnitude of the company's reach is evidenced by a product portfolio that spans several therapeutic classes, as well as vaccines and consumer goods. The diverse platform insulates the company from problems with any single product.
Royal Dutch Shell
Shell plans to dramatically reduce investment levels as new projects are completed by capping yearly capital spending at $30 billion through 2020, versus the nearly $50 billion it spent in 2014. The sharp decrease should improve capital efficiency, but should not completely sacrifice growth.
As a result of its collective efforts, including divestiture of capital-intensive low-return upstream and downstream assets, Shell should boost margins and improve returns by 2020, leaving it in a better competitive position.
Imperial Brands
Imperial Brands generates the highest tobacco operating margins among the large-cap manufacturers, but we think a multiple discount is still appropriate for the stock due to the firm's weaker volume trends, slightly lower brand equity, and its absence from the promising heated tobacco segment.
Nevertheless, equity analysts believe Imperial's pricing power, largely driven by the addictive nature of the product, give it a wide economic moat – competitive advantage over peers. Imperial's strategy to maximise shareholders returns revolves around cost optimisation and disciplined capital allocation.
