F O C U S Colin Morton, manager of the Franklin UK Equity Income Fund, presents the benefits of a large-cap-focused income strategy 1
Important Information For professional investor use only. Not for distribution to retail investors. The Franklin UK Equity Income Fund charges all of its management fees to capital. This could lead to a higher level of income but may constrain capital growth. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the Franklin Templeton Investments fund ranges. Nothing in this document should be construed as investment advice. Franklin Templeton Investments have exercised professional care and diligence in the collection of information in this document. However, data from third party sources may have been used in its preparation and Franklin Templeton Investments has not independently verified, validated or audited such data. Opinions expressed are the author s at publication date and they are subject to change without prior notice. Any research and analysis contained in this document has been procured by Franklin Templeton Investments for its own purposes and is provided to you only incidentally. Franklin Templeton Investments shall not be liable to any user of this document or to any other person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission. The Franklin UK Equity Income Fund launched on 17/10/11 to receive the assets of the Rensburg UK Equity Income Trust, a unit trust. Investments entail risks. The value of investments and any income received from them can go down as well as up, and investors may not get back the full amount invested. Past performance is not an indicator or a guarantee of future performance. For more information, visit: www.franklintempleton.co.uk. Issued by Franklin Templeton Investment Management Limited, Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorised and regulated by the Financial Conduct Authority. 2
FOCUS WELCOME Focus is a publication that brings you face-to-face with a selection of the most in-demand asset managers in the UK and across Europe. Colin Morton is something of an expert on UK equity income: he has managed money on behalf of investors for more than two decades and run the Franklin UK Equity Income Fund* since 1995. The fund has delivered a steady combination of capital growth and income over this period. Morton s large-cap, growth-focused investment process has remained unchanged since he began running the fund and it has helped him navigate a series of bull and bear markets. He explains why he only invests in attractively-valued, good-quality businesses with pricing power and cashflow-generating abilities. He also provides his view on equity valuations, alongside an outlook for how the UK equity market will fare in 2018. The Interview Colin Morton, Franklin Templeton Investments Fund Snapshot Franklin UK Equity Income Fund In association with Fund Manager Q&A Colin Morton, Franklin UK Equity Income Fund *Franklin UK Equity Income Fund launched on 17/10/11 to receive the assets of the Rensburg UK Equity Income Trust, a unit trust. 3
Franklin UK Equity Income: A conservative fund delivering above-average age returns
Colin Morton, Franklin Templeton Investments THE INTERVIEW The search for income among FTSE stocks tends to focus on the small number of mega-caps that account for a large proportion of the dividends paid. Some fund managers may feel stifled by the dominance of such stocks in the FTSE 100 particularly. However, Colin Morton, manager of the 404m* Franklin UK Equity Income Fund, believes his approach to this part of the index is helping him to deliver a healthy and sustainable level of income at a time when investors need it the most. Income investors face a difficult challenge currently because they are receiving zero on cash investments while short-dated government bonds of less than five years are yielding less than 50 basis points and 10-year government bonds are only providing 1%. Many investors in this space can end up dipping into their capital in order to supplement their income, explains Morton. Risk-averse While many investors feel they need to move up the risk scale and into high-yielding bonds or alternative assets in order to derive a healthy level of income, Morton s relatively risk-averse, large-cap investment approach has delivered an annual income growth rate of 5.5% over the last 20 years, well ahead of the corresponding rate of inflation at 2%* and the FTSE All Share index. We take a sensible approach to investing in UK equities and aim to deliver above-average returns without taking on huge amounts of risk, he says. If you look at the beta of this fund s portfolio then it is very evident that we are less risky than our peers in the market. Morton argues the simplistic nature of the strategy and a focus on good quality and highdividend paying companies is important in today s complex economic environment. He believes his strategy resonates with investors searching for income due to the fact it is a completely transparent, long-only portfolio. Stock selection Morton uses a combination of bottom-up and top-down processes to select stocks for the portfolio, which has a minimum of 70% invested in the FTSE 100. Despite the FTSE 100 being a reasonably consistent list of companies, it s important that income investors don t start with a blank sheet of paper, says Morton. You must start by looking at where the yield is coming from in the market and analyse what *Source: Franklin Templeton Investments. As at 31 July 2017. 5
I do not let yield be the sole consideration of the stocks I invest in
Colin Morton, Franklin Templeton Investments THE INTERVIEW percentage of the overall market yield those stocks account for. As an income manager, I also focus on the type of economic environment we are in; whether it is a cyclical or defensive cycle, or if I am willing to pay more for high-quality stocks because we are in a low growth and low inflationary world. Though he understands the lumpy nature of the FTSE 100, where around 30% of the market yield is derived from just four or five companies, he tries to take a practical approach, arguing such figures are a reality of life. Yield requirements Morton explains: I do not let yield be the sole consideration of the stocks I invest in, which is very important to this strategy. If a company meets all of our criteria but is not, for example, using its free cashflow to pay * Past 20 calendar years to end December 2016 FRANKLIN UK EQUITY INCOME FUND 5.5% AVERAGE ANNUAL INCOME GROWTH RATE DELIVERED BY THIS FUND OVER THE PAST 20 YEARS* as much in dividends because it is growing the business or conducting bolt-on deals they believe will add long-term quality to their business, I don t want to miss out on it because it has a lower yield. Morton often allocates a small part of his portfolio to such stocks citing that a pragmatic and flexible approach is important alongside his large-cap focus, particularly as he anticipates that many of his lower-yielding holdings will deliver significant dividend growth in the future. Economic environment Downside protection is also a core part of the analysis process in this strategy and no stock makes up more than 5% of the fund s portfolio so as to avoid stock-specific risk. In addition, some companies are avoided altogether in order to protect investor capital and maintain the fund s conservative outlook. He explains: We would never invest in a stock if future returns were reliant on a single specific issue. In the mining sector, for example, we recently avoided highly leveraged stocks that were too reliant on iron ore or copper price appreciation. We did invest in the sector, due to the potential for upside, but stuck to more diversified companies which had stronger balance sheets and better profit margins. 7
NEED TO KNOW Franklin UK Equity Income Fund FUND MANAGEMENT TEAM Colin Morton Lead manager 35 years experience Specialisms: UK large-caps Mark Hall Deputy manager 30 years experience Specialisms: Multi-cap UK equities Ben Russon Deputy manager 18 years experience Specialisms: UK equities TYPICAL NUMBER OF ASSETS INVESTED IN FTSE 100 COMPANIES 80% HISTORIC YIELD 4.05% AVERAGE ANNUAL INCOME GROWTH 1996-2016 5.5% TOP 10 SECTOR ALLOCATION 8.26% OIL & GAS PRODUCERS 8.11% PHARMACEUTICALS & BIOTECHNOLOGY 7.45% GAS, WATER & MULTIUTILITIES 6.49% TOBACCO 4.41% BANKS 4.37% MEDIA 5.51% FINANCIAL SERVICES 5.42% LIFE INSURANCE 4.14% BEVERAGES 4.06% PERSONAL GOODS 8 Source: Franklin Templeton Investments. As at 31/07/17
Franklin UK Equity Income Fund FUND SNAPSHOT 1,200 900 600 300 Franklin UK Equity Income: Income generated on 10,000 invested Franklin UK Equity Income Fund FTSE All-Share Index Colin Morton remains committed to providing a premium yield on the Franklin UK Equity Income Fund, and aims to exceed 110% of the FTSE All Share index yield. Over the past 20 years, the fund has successfully delivered an average annual income growth rate of 5.5%, well ahead of the corresponding rate of inflation of 2%. 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Franklin Templeton Investments. Investment period from 1 January 1996 to 31 December 2016 Discrete Annual Performance June 16 June 17 June 15 June 16 June 14 June 15 June 13 June 14 June 12 June 13 Franklin UK Equity Income Fund W (acc) 17.77% 6.78% 6.18% 15.60% 20.16% FTSE All-Share Index 18.12% 2.21% 2.60% 13.12% 17.93% 10,000 invested over Colin Morton s tenure from 1 January 1995 to 30 June 2017 would now be worth 88,846. This equates to an average annual total return of 10.19%. In addition, over five years to 31 July 2017, the fund has delivered a total return of 82% versus the IA UK Equity Income average of 73% and FTSE All Share s 65%. Source: Franklin Templeton Investments & Morningstar as at 31/07/17. Performance data shown are in GBP and includes reinvested dividends net of basic rate UK tax and are net of management fees. Sales charges and other commissions, taxes and other relevant costs paid by the investor are not included in the calculations. Past performance is not an indicator or a guarantee of future performance 9
FUND SNAPSHOT Franklin UK Equity Income Fund The challenge for the UK Equity Income sector over the coming months will not be the often-discussed search for dividends, but how managers will navigate the potential volatility of the domestic UK equity markets. Here, researcher PureGroup s exclusive analysis of the Franklin UK Equity Income Fund shows how it is positioned against a range of macroeconomic factors, and why the Fund is less likely to be impacted by market declines than its peers. The arrows within each chart depict which direction the specific macroeconomic factor is likely to move in over the short term. The positioning of the fund and peer group on each chart reveals how sensitive the Fund and peer group are to each of the factors. Positive sensitivities to a factor indicate an investment is likely to have a positive contribution to its performance if the factor increases or expands. A negative sensitivity suggests an investment is likely to have a positive contribution to its performance if the factor decreases or contracts. The size of sensitivity indicates the relative significance of the expected contribution. 10 2.00 1.50 1.00 0.50 0.00-0.50 UK default spreads Factor direction: Falling UK default spread is the measure of yield difference between high quality (AAA) and lower quality (BBB) corporate bonds. The reason this factor is analysed here is because it is a good leading indicator of business uncertainty, as during periods of increased market stress investors expect to be compensated more for the risk that they are taking. This causes the default spread to expand as lower quality corporates need to offer a higher yield. Importantly the Franklin UK Equity Income fund is neutral to this factor (which is falling currently), and therefore it is likely to be less impacted by any unfavourable news or increase in market volatility. UK dividend yields 15.00 10.00 5.00 0.00-5.00-10.00-15.00-20.00-25.00-30.00 Factor direction: Falling
In association with Franklin UK Equity Income Fund FUND SNAPSHOT Looking at wider equity market valuations, the Franklin UK Equity Income fund has a positive sensitivity to UK dividend yields. The movement of this factor during an economic cycle has two drivers: the overall dividend and its underlying valuation. Long-term central bank quantitative easing policies have led to a broad appreciation of most global equity markets. It is this valuation increase that has the biggest current impact on the factor. The fund s positive sensitivity means that currently it would face a headwind to its performance. However, if valuations were to fall back, then the Franklin UK Equity Income Fund would be expected to outperform the peer group. UK term spreads 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00-0.25 Factor direction: Rising 3.00 2.50 2.00 1.50 1.00 0.50 0.00-0.50-1.00-1.50 UK interest rates Factor direction: Rising Primarily, there have been two levers that have been used by central banks to stimulate the economy, the first is to reduce interest rates to near zero levels and the second is to have asset purchase programmes to repurchase issued government bonds. Global central banks are all at different stages of progress on their own QE programmes, however most have either started or will be looking to initiate a removal of these monetary policies over the coming months and years. Monetary tightening is likely to see domestic shortterm interest rates increase. UK term spreads (the difference in value between long and short-dated government bond yields), are also likely to increase. In both of these scenarios, the Franklin UK Equity Income Fund would have a positive impact to its expected return. Franklin UK Equity Income Fund Peer group 11
FUND MANAGER SNAPSHOT Colin Morton Colin Morton has a uniquely successful track record specialising in large-cap UK equity analysis and investment. It has resulted in him performing significantly better than the peer group composite over both the longerterm and shorter time periods. 250 200 150 Colin Morton Colin Morton performance vs peer group Peer group composite Since 2000, he has returned 223% in total return terms versus a peer group average of 156%. 100 50 0-50 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 12 Source: FE. As at 1 September 2017
Colin Morton, Franklin UK Equity Income Fund FUND MANAGER Q&A As investors approach 2018, how would you describe the UK equity market today? Valuations remain elevated, supported by extremely low bond yields and short-term interest rates being close to zero. In 2016, due to significant overseas earnings, the UK market received a one-off boost following the post-brexit-vote devaluation of sterling. Progress in 2017 has been harder to come by as focus has switched to what the world s central banks will do next as they move towards the normalisation of monetary policy. Thus far, the UK economy has proved remarkably resilient despite the challenges presented from rising inflation and a squeeze on real wages. GDP growth is forecast to be in the range of 1.5% to 2.0% for 2017, with a modest slowdown in 2018. In this environment I believe it is realistic for investors to expect mid-to-high single digit returns per annum from the UK equity market over the medium term. Should investors be concerned about inflation and its impact on the market? I would be more concerned by the likely increase in inflation if it was being generated by demand factors. However, the current spike in inflation is clearly resulting from the devaluation of sterling in the wake of the EU referendum. Sterling has fallen by more than 10% on a tradeweighted basis and this has inevitably pushed up input prices which are now being passed on to consumers. I expect inflation to peak in the next few months and start to fall back towards 2% in 2018. It appears increasingly likely that the Bank of England will take the opportunity in November to reverse last August s emergency quarter point cut in interest rates, however, I do not expect this to have a major impact on the market. Do you believe the UK equity market is overvalued? It is rarely straightforward to make absolute judgements on the valuation of the equity market. Whilst equities, on a price earnings basis, do look quite expensive compared to their longterm average valuations, they actually appear undervalued relative to bonds. In the UK, 10-year Government bond yields are currently 1.3%, this compares to an earnings yield from UK equities which is in excess of 5%. Add on the benefits to equity returns from economic growth and you get to a very healthy equity risk premium. It is this factor which is helping to underpin the equity market at a time when there are few, if any, attractive alternatives. Over the medium term we would expect 10-year bond yields to increase from their current low 13
FUND MANAGER Q&A Colin Morton, Franklin UK Equity Income Fund levels but we believe they would have to rise to over 3% to threaten equity valuations. Our analysis suggests the equity market is already pricing in bond yields returning to a range of 2% to 3%. Do you think the high dividends currently being paid by some of the mega-cap stocks are sustainable? Under certain circumstances, they are sustainable and in under other scenarios they are not. The more important point is that the yields on these stocks are high because of the risk. Some well-known managers have dropped out of the IA UK Equity Income sector because they were not willing to buy some of these high yielding stocks and consequently did not meet the sector s (original) 110% yield requirement. However, I take the view that one of the important reasons for the equity income sector s long-term outperformance is the willingness of some income fund managers to buy the higher yielding out-of-favour sectors. It ultimately comes down to a compromise: what allocation do I need to have in these companies in order to reach my overall yield target for the portfolio? In the case of oil and gas, the sector makes up around about 15% of the FTSE 100 Index. I have allocated around 8% of my portfolio between BP and Shell and they have done extremely well over the past 12 to 18 months. The jury is still out on their business models and whether or not at the current oil price they will start to pay dividends from cashflow in 2017. But the point is, they are still yielding 6.5% against a market yield of 3.5%. So, I am receiving double the market yield for taking the risk associated with these stocks. I would not invest a large proportion of my portfolio in this area, but neither do I want to avoid them completely. 14
The jury is still out on BP and Shell s business models. But the point is they are still yielding 6.5% against a market yield of 3.5%. I am receiving double the market yield for taking the risk 15
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