How the top performing UK Equity income fund picks stocks

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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 avoid packing the fund with the same 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 daughter’s two-year-old 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]

[1]Past performance is not a reliable indicator of future results. Source: Lipper to 26/11/21. Returns are based on published dealing prices, single price mid to mid with net income reinvested, net of fees, in sterling. Investment Association performance represented by the average fund performance of respective IA total return sectors.

Here’s how I did it. 

Too many eggs in one basket

Ten of the biggest FTSE 100 companies make up more than half of all UK dividends.[1]

If you look at most traditional UK equity income funds, they’ll usually hold 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. 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

Large companies are popular with investors because they can pay out chunky dividends. 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.[2]

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

For example, in the pandemic many traditional UK income stocks cut their dividends, with pay-outs falling by 44% in 2020.[3]Whilst these dividend pay-outs are now recovering from these low levels, we don’t think that these stocks will 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 the big income stocks, without compromising on targeting an attractive income stream. 

Smaller and medium-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.

To help, I’m backed by the Octopus Quoted Companies team. We are a 9 strong, highly experienced investment team with a proven performance track record. We attend over 850 company meetings a year to identify the best investment opportunities. The average tenure of the team is 12 years, and we manage over £2.9bn[4]across all our mandates including 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

The fund takes a “core and satellite” approach. The core is made up of companies that we believe can grow earnings and dividends ahead of the market. We’ll 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, I 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. 

We remain upbeat about the prospects for the FP Octopus UK Multi Cap Income Fund and I’d like to thank everyone who has invested with us so far.

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. 


Risks to bear in mind

The value of an investment can fall or rise and you may not get back the full amount you invest. Smaller company shares are also likely to fall and rise in value more than shares in larger, more established companies listed on the main market of the London Stock Exchange. They may also be harder to sell. 

Our investments are not suitable for everyone. We do not offer investment or tax advice. Personal opinions may change and should not be seen as advice or a recommendation. Before investing you should read the Prospectus, the Key Investor Information Document (KIID) and the Supplementary Information Document (SID) as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The Prospectus, KIID and application forms are available in English at The Authorised Corporate Director (ACD) of these funds is FundRock Partners Ltd which is authorised and regulated by the Financial Conduct Authority no. 469278, Registered Office: 8/9 Lovat Lane, London EC3R 8DW. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London EC1N 2HT. Registered in England and Wales No. 03942880. November 2021. CAM011582.

[1]Source: AJ Bell Dividend Dashboard 30/06/21

[2]Source: Factset, 24/06/21

[3]Source: Citywire, 28/09/2021 ‘Investors lose appetite for UK Equity Income’  

[4]Source: Octopus 31/10/21

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