How the top performing UK Equity income fund picks stocks

Over three years, FP Octopus UK Multi Cap Income Fund tops the IA UK Equity Income Sector. What’s the secret to its success? Chris McVey, lead fund manager, explains his approach and what it can offer investors.

Three years ago, we launched an equity income fund with a difference.

Our idea was simple – to construct an equity income product that was capable of delivering better than market earnings and dividend growth through the cycle.

We felt this would be best achieved by leveraging our team’s capabilities and expertise to take a multi-cap approach to portfolio construction. We focus on faster growth, progressive businesses, and avoid packing the fund with many of the same low growth, often ‘sunset industry’ stocks you’ll find in most traditional UK equity income funds.

The fund launched at around the same time as I had my first child. Managing a young fund arguably has some parallels with having a young child. Both need constant attention, and both will take time before their personality becomes fully formed.

Whilst the fund, thankfully, has not demonstrated any of my two-year-old daughter’s temper tantrums, since day one, we have had some incredibly challenging market conditions.

Brexit negotiations continue to rumble on, whilst a global pandemic has added to the mix. Extreme market volatility, uncertainty and widespread dividend cuts have all added to the fun.

Less than ideal conditions for a fledgling fund. So how did it perform?

In the three years since it launched, FP Octopus UK Multi Cap Income has returned 69.8% placing it 53.5% ahead of the average fund return within the IA UK Equity Income sector.¹

Year to 26 November	26/11/18 – 26/11/21	2021	2020	2019	2018	2017
FP Octopus UK Multi Cap Income S Acc	69.8	28.0	6.3	24.8	n/a	n/a
IA UK Equity Income Sector – Average Fund Total Return	16.3	18.2	-9.9	9.2	-3.5	12.5
FTSE All-Share Index Total Return	15.8	15.7	-9.6	10.7	-1.5	13.5

How was this achieved? When looking to develop this strategy we identified three key risks potentially impacting a significant proportion of the rest of the UK Equity Income sector.

Significant holding concentration across many of these ‘traditional’ equity income funds, low dividend cover amongst many of these holdings, and low potential growth. Our multi-cap strategy was developed to mitigate some of these concerns and offer investors true diversification when considering their UK Equity Income options.

So far, the fund has delivered outperformance against the wider IA UK Equity Income sector just as we would have hoped.

Too many eggs in one basket

Ten of the biggest FTSE 100 companies make up more than half of all UK dividends.

If you look at most traditional UK equity income funds, they’ll usually hold many of these same stocks.

This concentration could be a big problem for investors.

Firstly, you’ll be very exposed to the performance of just a few companies. And secondly, holding multiple income funds to provide diversification is unlikely to have the desired effect.

Whichever way you cut it, the chances are you’ll remain over-reliant on these few large companies. If these companies don’t perform, neither do the funds you hold.

You might be wondering, then, why all these funds are holding the same stocks. The answer is obvious. These income stocks pay out a large proportion of their earnings as dividends. In our view many of these companies were over-distributing over recent years. But what happens when they don’t?

Big dividends are rarely matched by earnings growth

Some of these stocks are popular with investors largely because they can pay out chunky dividends – not because of their exciting growth dynamics.

These companies also know their investors typically hold shares specifically for the dividend, meaning they will focus on maintaining, or even growing it a little each year.

And while the average dividend per share growth has been strong for the ten largest FTSE 100 stocks pre Covid at more than 12%, what was concerning us was that the average earnings per share growth for the same companies over this period has been a meagre 3.3% per annum.

Without growth in earnings, it’s harder for a business to sustain increases in dividends indefinitely. It’s also more likely that such a company might need to cut its dividend in the event of a shock.

This was exactly what we saw with the pandemic, with many traditional UK income stocks cutting their dividends, with pay-outs falling by 44% in 2020. Whilst these dividend pay-outs are now recovering from these low levels, we think that these stocks won’t be able to reinstate dividends back to pre-crisis levels any time soon.

The multi cap approach

The good news is there’s a way to limit your exposure to these big income stocks, without compromising on targeting an attractive and growing income stream.

The Octopus Quoted Companies team is made up of 9 investment professionals with a long track record of investing in UK small and mid-sized companies. We look across the entire UK equity market and don’t just focus on the big traditional income stocks. Taking this approach, means investors should benefit from a progressive equity income stream that’s capable of better than market growth through the cycle.

Smaller and mid-sized companies can lie in a sweet spot of earnings growth, underpinning progressive dividend growth. Whilst the fund has around 25% of its holdings in companies larger than £1 billion, we have found that UK companies valued above £100 million, but below £1 billion, are often on a steady growth trajectory and can pay increasingly attractive dividends. These companies are the focus of our fund, despite them being largely overlooked by most traditional UK equity income funds.

We take a fundamental, bottom-up investment philosophy to portfolio construction and meet over 850 companies a year to identify the best investment opportunities.

The average tenure of our team is 12 years, and we manage over £2.9bn[1] across AIM VCTs, AIM Inheritance Tax products as well as three funds: FP Octopus Multi Cap Income, FP Octopus UK Micro Cap Growth and the recently launched FP Octopus UK Future Generations fund. And, like three years ago, I have also just had my second child…

Investing in smaller companies can carry more risk

The value of an investment, and income from it, can fall as well as rise. Investors may not get back the initial amount invested. While smaller companies can offer benefits for an equity income portfolio, you must also consider the additional risk this involves.

Please remember that investing in smaller companies can involve greater risk than may be associated with investing in larger, more established companies.

The share prices of smaller companies can fluctuate more in value than their larger counterparts. The shares may also be harder to sell.

Investment approach – Core and Satellites

As with the other OEICs, the fund utilises our “core and satellite” approach to portfolio construction.

The core is made up of companies that we believe can grow earnings and dividends ahead of the market. We look for robust finances, superior prospects for profit growth, appropriate balance sheets and good earnings visibility.

The satellite positions are designed with two key attributes in mind – income or growth.

The income satellites are those companies potentially delivering superior, sustainable dividends albeit with lower near term growth characteristics.

Whilst the growth satellites are expected to demonstrate exceptional growth opportunities albeit with lower near term dividend expectations.

Our fund isn’t constrained by investing in any one part of the market. Instead, we look at every company and ask:

• Can it offer a dividend yield greater than the wider market?
• Can it deliver faster than market earnings growth?
• Can it deliver faster than market dividend growth?

Asking these questions helps unearth potential income stars of the future, long before other income funds would consider them. The key point is that each holding provides at least one of these three characteristics.

This focus has enabled us to develop a portfolio which has delivered better than market capital performance, coupled with an attractive and growing dividend yield. Hopefully, this can continue.

As always, past performance can’t be used as a reliable indicator for future performance. However, we believe the fund with its solid and differentiated investment process, delivered by experienced management, will continue to deliver impressive risk-adjusted returns.

Here’s a closer look at three great companies in the portfolio:

Why now is the time to consider a multi-cap approach to UK equity income

Five years ago, we launched an equity income fund with a difference. Our idea was simple – to construct an equity income product that was capable of delivering better than market earnings and dividend growth through the cycle.

Hear from Chris McVey, lead fund manager of the FP Octopus UK Multi Cap Income Fund, who’ll explain the benefits of the fund’s broad investment universe, its core-satellite investment approach and why he believes now is the time to invest in the UK.

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