At 5.75%, the yield on JOHCM UK Equity Income (B8FCHK5) is the second highest it has ever been, according to fund manager Clive Beagles. You have to go back to the global financial crisis in 2008, when stock markets collapsed, to find a higher yield on the fund.

‘I find that staggering because the balance sheets of our companies are in a miles-better place than in 2008,’ he says. ‘We only own three companies with net debt/EBITDA of more than two times. One third of the companies in the fund have net cash and the dividend cover (ratio of earnings to dividends) is the highest it has ever been.’

The £1.5 billion fund invests in UK stocks and has a value tilt – two things currently out of favour with investors. However, it provides investors with an opportunity to access decent companies at an attractive price. That is the foundation for a successful investment strategy over time.

Traditionally a high yield either suggests the market is worried about something wrong with a company, its dividend is too good to be true or because there are low growth prospects and it has little else to do with its spare cash than return it to investors.

Yet occasionally you can find high-yielding companies that simply out of favour but are offering good earnings growth and the financial strength to return generous dividends, and those qualities are ones sought by the JO Hambro fund.

HOW HAS THE FUND PERFORMED?

JOHCM UK Equity Income seeks companies paying an above-average dividend yield, which are attractively priced, and collectively have the potential to grow dividends each year by high single digits.

Since launch 19 years ago, the fund has grown its dividend by 9% on average each year. Its annualised total return since inception has been 8.2% versus 6.7% from the FTSE All-Share index, according to FE Fundinfo, and it has a 0.71% ongoing charge.

‘People are very negative about the UK,’ says Beagles. ‘We have not helped ourselves as a nation – our politics have been very messy for six to seven years so it is easy for international investors to not bother with UK stocks. Investors also still seem obsessed with tech and go-go growth even though discount rates have gone up, which to us looks slightly odd.

‘The value of cyclicals relative to defensives is at a 50-year low. I do not think the world is in the gloomiest place it has been in for 50 years. To us it is an interesting time as valuations look attractive with UK stocks.’

WHAT’S IN THE PORTFOLIO?

One third of the fund is in financials, namely a mix of banks and insurance companies. Shares in banks rapidly went out of favour earlier this year when Silicon Valley Bank and Credit Suisse got into trouble, with stocks indiscriminately hit across the sector. The JO Hambro fund has stakes in the likes of Barclays (BARC) and NatWest (NWG) and both stocks have yet to recover from the February sell-off.

Aviva (AV.), Legal & General (LGEN) and Phoenix (PHNX) are the three insurers in the fund’s portfolio, and Beagles says they are as big a beneficiary of rising interest rates as banks, as that is driving demand for bulk purchase annuities.

‘When interest rates were close to zero, pension funds could not do anything. Now that rates are higher, deficits have reduced or removed, and companies are going to want to remove that risk from their balance sheet via a bulk purchase annuity.

‘We think bulk purchase annuity volumes will be double or more this year versus last year – that growth could go on for three to four years. Yet look at valuations for those three stocks, they all trade on single figure multiples and on dividend yields of 8% to 9%, even though there is a structural tailwind ahead of them.’

STAYING CONFIDENT ON NATURAL RESOURCES

Concerns about a global economic slowdown have weighed on the mining and energy sectors in recent months, causing a drag on performance for the JO Hambro fund which has exposure to names such as BP (BP.) and Shell (SHEL). Bank of America’s latest survey of fund managers around the world even shows the lowest allocation to commodities in three years.

The JO Hambro manager seems relaxed, taking a long-term view on both sectors due to what is happening with supply and demand.

Oil companies have pulled back on investment in new capacity in recent years and yet it is clear that fossil fuels will still be in demand for a long time to come, despite efforts to shift the world to renewable energy. That suggests supply constraints down the line which could be supportive for the oil price.

UK oil producers typically trade on lower multiples of earnings than US peers, meaning the fund has cheaper exposure to a sector that is still generating significant amounts of cash. ‘BP and Shell are on about five times earnings and returning 15% of their market value every year in buybacks and dividends.’

Shares in mining companies are influenced by GDP forecasts, what is happening with Chinese construction and manufacturing activity, and prices of the products being extracted and supplied. Beagles has selected certain miners to get exposure to metals needed for the energy transition including copper and cobalt.

‘We will need an awful lot more of these transition metals and I do not think there will be enough supply. We are hardly discovering any more copper in the world, but where we are discovering it is in difficult political jurisdictions or difficult geological locations, and yet we need 50% more copper in 10 years’ time than we have today if we are to meet the ambitions for electric vehicle rollout and recharging networks.’

THE AIRLINE OPPORTUNITY

Shares in EasyJet (EZJ) have risen by 50% so far this year and Beagles believes there is more to come. He holds the airline in the JO Hambro fund and, while it does not feature in the portfolio’s top 10 holdings, the manager observes, ‘it is a big stock for us’.

There has been a strong recovery in travel demand post-pandemic despite the cost-of-living crisis, and EasyJet has made strategic changes to take advantage of this market dynamic. The business is bouncing back from Covid disruptions, but the market is not fully pricing in its capabilities, judging by the cheap share valuation. The shares trade on less than 10 times forecasts earnings for the year to September 2024.

‘We spend a lot of time trying to think about earnings in more normal conditions,’ says Beagles. ‘EasyJet might get back to about 3.5% operating margin this year. Historically it made more like 8% to 10%. Can it get back to that level? Absolutely.’

EasyJet has focused on getting more money from customers through ancillary services and has also launched a package holiday business which is proving to be a big hit. The business launched just before the pandemic struck and could make £85 million of operating profit this year, according to Beagles. ‘We think it could soon make £200 million of incremental profit in a year. Put that together, we think EasyJet could make over 100p of earnings in three to four years’ time. Yet the shares are still only around 480p today which to us looks quite modest.’    

While EasyJet has not paid a dividend since the pandemic struck, it is quite common to see income funds own such stocks if they believe the company could reintroduce the shareholder reward in the future.

IS THE FUND WORTH BUYING?

If you are looking to take advantage of cheap valuations among UK stocks and get a decent income, JOHCM UK Equity Income has a lot going for it. Like any investment you will need to be patient and accept there will be good times and bad. But having low valuations is a great starting point and this has them in spades. ‘We find an awful lot of modestly priced shares in our market,’ concludes Beagles.

‘When I started in the finance industry the UK was the second largest stock market in the world. Today the market cap of the FTSE 100 is less than Apple (AAPL:NASDAQ) .

‘Ultimately Apple is close to being a single-product company, whereas we have tremendous diversification across the FTSE 100 – which of those is least risky? Most global investors have more in Apple than in the UK stock market, I suspect. That is what needs to evolve and change, and there are signs that is beginning to happen. There are takeovers and a growing realisation that the UK economy is doing ok. But that valuation gap just looks too big.’

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