Where we are shopping for UK dividends

Clive Beagles, manager of JOHCM UK Equity Income IP GBP Acc (B8FCHK5) fund, explains how he seeks out dependable dividend-paying stocks and attempts to avoid value traps. 

Beagles picks out two stocks he’s finding plenty of value in – a high yielder and a lower yielder that in future could pay a bumper dividend. The £2 billion fund has a third of its exposure in financials. Beagles explains why he’s a fan of bank shares and how he’s tweaked exposure following a strong share price run in that area. 

The fund manager also explains why the fund’s exposure to mid-caps and small-caps is at an all-time high since it launched 22 years ago.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Clive Beagles, manager of the JO Hambro UK Equity Income fund. Clive, thanks for joining me today.

Clive Beagles, manager of the JO Hambro UK Equity Income fund: Great to be here.

Kyle Caldwell: So Clive, to kick off could you give a brief summary of how the fund invests and how you differ from the competition?

Clive Beagles: Yeah, I guess there’s a number of points of differentiation, but maybe just focusing on a couple to begin with.

First, we invest across the whole of the market cap spectrum. So large cap, mid cap, and small cap. Almost 50% of the fund is in mid- and small-cap stocks. So, that means market capitalisations of less than, say, £4 billion in the UK. 

That’s different to many other competitor funds in our sector that tend to be much higher up the market cap scale and focus on the larger companies. We think we can find more mispriced stocks among the mid- and small-cap arena.

Second, we tend to try and find significantly undervalued companies that happen to offer a superior dividend yield or some other valuation metric that we find attractive, many of which might be a relative low point in their own cycle. So, they have recovery-type characteristics.

Whereas I think with a number of other funds in our sector, fund managers behave a bit more like bond managers. They’re almost just looking for safe, steady 4% dividend yields that they know are safe and secure, but where there won’t be a great deal of upside from a capital point of view.

So, I think those are the things I’d call out the most as being different about what we do.

Kyle Caldwell: As you just mentioned, the fund has an emphasis on stocks that have higher yields than the wider market. So, how do you judge a potential opportunity from a potential value trap?

Clive Beagles: Yeah, value traps are the hardest things to avoid, particularly in the world of recovery, turnaround. At its simplest, value traps tend to occur where a company is making a certain amount of profitability today, but where there’s a permanent structural change going on in their industry that means in the future they won’t make as much profitability.

So, we’re constantly on the lookout for structural change, maybe structural change that’s being underappreciated by markets and so forth.

The best way maybe to think about that would be an example. Look at, say, quite a high-profile company like Diageo (LSE:DGE), which is one of the largest spirits companies in the world, big positions in whiskey, tequila.

But we think that as a company it has been overearning for a number of years. They’ve continued to push prices higher, ever higher and higher and higher. They got a bit carried away during Covid when people were at home and had nothing else to spend money on other than treating themselves in that regard.

We think prices have reached an unsustainable level and, actually, they’ve lost market share to start-up brands or own brands and so forth. At some point we think there will have to be quite a significant price reset and margin reset.

The shares haven’t performed very well and people keep asking us, why haven’t you bought them yet? And to us, we still think it’s a bit of a value trap.

You’re never going to get all those right.

The flip side of that is that if you do buy a stock and you become concerned about it, then take action rather than just sticking your head in the sand and automatically doubling up just because the shares have gone down. Just constantly try and think about each company you own with a fresh set of eyes, a fresh sheet of paper. And try and work out whether that investment thesis is applicable.

• What a Burnham premiership could mean for your long-term wealth
• Fund Focus: where Baillie Gifford has - and hasn’t - recovered

Kyle Caldwell: In terms of scrutinising the sustainability of a dividend, are there certain metrics such as dividend cover that you hold in a higher regard than others?

Clive Beagles: Compared to others we spend a lot more time looking at balance sheets. We think people are a little bit lazy about balance sheets. 

So, a company might have high dividend cover, but it’s got an awful lot of leverage. Then if the earnings start to come under some degree of pressure, they might cut the dividend quicker than a company that, say, got net cash on the balance sheet, but actually the dividend cover might be lower, but, actually, it’s got the financial wherewithal to maybe manage a short-term downturn in its earnings, for example. 

We only have two or three stocks that have net debt to EBITDA, which is a metric people tend to look at for leverage of over two times. Diageo, we talked about just now, is a stock that’s got much higher leverage than that. I think that’s one of the reasons why that stock’s been struggling.

Almost 20% of the stocks in our fund actually have net cash on their balance sheet. So, they may have some cyclicality, but if they have cyclicalty, we’d like to have a strong balance sheet to offset the risk of not knowing quite how the cycle is going to play out.

Kyle Caldwell: And how do you try and get the balance right in terms of capital growth and income growth? As there can be occasions in which certain companies will over-prioritise a dividend and that can come at the expense of growing their business organically or using money to fund a potential acquisition.

Clive Beagles: We want our companies to grow. We’re not in the job of beating our companies up and demanding they give all their available cash back to us every year, because that’s a short-term strategy. And that applies to whether we’re talking about dividends or buybacks or a combination of both.

We want companies to organically invest, to have to use part of their free cash flow to maybe make the odd bolt-on acquisition if it increases their market share or position, and then just pay a sensible but predictable level of dividend which we think can grow through the cycle [with] enough cushion, so that if the cycle works against you for a year or two, you can still pay that dividend. And that is a balance.

But if you have companies that grow, then you’re going to have higher future dividends in years to come rather than just focusing on the here and now.

So, while our fund has a higher than average dividend yield, we’re not necessarily particularly focused on the highest-yielding names because they may be ones that have structural challenges ahead of them or maybe are over-distributing or maybe have too much leverage for our appetite.

So, it’s about trying to find a balance between all of those, but we really want our companies to grow. If they grow, then we’ll have strong total return including dividend delivered.

Kyle Caldwell: Could you perhaps give a couple of examples of stocks held in the fund today, perhaps a stock that’s more of a high-yielder and one that’s a lower-yielder today, but [where] the dividend growth is potentially going to come through in future?

Clive Beagles: At the high-yielding end about a third of our fund is in financials. Banks have done very well more recently. But within the financials area, an area that we’ve been adding exposure to in the last couple of years has been real estate.

I talk about a company called Hammerson (LSE:HMSO), which is the largest owner of retail shopping centres in the UK. If you went back 20 years ago, those were very popular. They were on the highest valuation and the lowest yield compared to other bits of property, say offices or industrial.

Because of the emergence of online shopping, which then led to the demise of department stores like House of Fraser and Debenhams, and these guys going out of business, they had to replace an awful lot of tenants with new tenants.

But, actually, today the dominant, say, 15 largest shopping centres in the UK, they own, for example, Brent Cross, the Bullring in Birmingham, they’re in Westquay in Southampton, so they’re really dominant out-of town, or indeed centre-of-town, shopping centres. They’ve seen footfall grow the last two or three years, they’re seeing rental growth and they’ve got all their centres full. 

They’re beginning to attract digitally native brands like Nespresso or Tesla or all these kinds of names which are almost using space in a large shopping centre as a sort of showroom rather than just thinking about making sales through that space.

And yet, the sector is still deeply out of favour, so it’s classic stuff we look for. Here’s a sector out of favour, a company that used to be in the FTSE 100, hasn’t been in the FTSE 100 for years. Many people thought it went bankrupt, which it didn’t by the way, but it’s fallen off their radar when, actually, the fundamentals have been improving and the share price hasn’t yet noticed and it’s begun to pick up a little bit.

So, that will be a share that’s yielding sort of 5.5%. But, actually, we think it has good scope to grow and we think the valuations will grow.

Maybe at the lower ending, much lower yielding, but a company that everyone will have heard of, is Marks & Spencer Group (LSE:MKS).

It is a company which I suggest got its mojo back two or three years ago with a new chief executive. It has dramatically gained share in food. It’s food market share has almost doubled over the last five or six years. This is interesting because it happened during a period of very high food price inflation and most people would associate much of the food with being at the quality, more expensive end, but they’ve almost gained share from people eating out less and treating themselves at home more with higher-quality food.

[In terms of] dividend cover, they’ve been very miserly so far in terms of distributing their better profitability to shareholders and they were probably just about to, and then they had their cyber incident, which set them back for nine or 12 months.

The result being that their dividend cover today is 8x. The average company in the UK, as you know, is about 2x. So, on the face of it, Marks & Spencer’s is a share that only yields, say, 1.5%. But, actually, if it moves to a sensible payout ratio or dividend cover of maybe 3x, it could easily be paying a dividend twice as high as the current number or even three times as high, particularly because we think the earnings have the potential to be meaningfully higher than what they’re reporting today as they continue to grow share in food and improve their margins in their clothing and home business.

So, that’s a share that I would say, looking out four or five years, is on a very healthy yield and we would expect strong dividend growth over the next few years.

One other element they were worried about [was the] pension deficit. They wanted to pay that down and that’s disappeared now. Their reasons for being cautious are increasingly being knocked down. I think now we’re through the cyber incident I’d expect that process to begin in the next 12 months or so.

• The smaller company funds offering big yields
• How to capture the emerging markets rally

Kyle Caldwell: You mentioned that the fund invests across the UK market in companies of all sizes. Earlier this year, the average yield on a mid-cap company was actually higher than a company in the FTSE 100. I think it’s the first time that’s happened in around 20 years. Does that mean you’re finding more opportunities now in that area?

Clive Beagles: Yeah, I mentioned at the start that we were about 50% invested in mid- and small-cap and 50% in the FTSE 100. That’s the largest weighting we’ve had in mid- and small caps since we started the fund 22 years ago. Why is that? 

For exactly the reasons you highlight, the valuations have become quite skewed. Actually, if you look at the valuation gap from a valuation premium that FTSE 100 stocks trade on to mid-250 stocks, it’s higher than it was after the Brexit referendum when there was an awful lot of economic uncertainty, and higher than it was at the worst point of Covid. So, that seems quite extreme, not everything is perfect in the UK economy, we’ve got some issues to work our way through, but actually the situation is nowhere near as uncertain or indeed as dangerous as it was during those two periods.

So, that would suggest to us that, if we keep looking in that FTSE 250 area, we’re more likely to find significantly undervalued shares, and that’s exactly what we’ve been trying to exploit.

Kyle Caldwell: BP is the top holding in the fund. It has been an eventful couple of weeks for the firm with the shock ousting of board chair Albert Manifold who had been leading a cost-cutting and restructuring plan. What is your view on BP (LSE:BP.) and has it changed in light of recent events?

Clive Beagles: Yeah, look, it’s been a very noisy period for BP, and not just the last few weeks, to be honest, the last two years.

If you remember, they had a period where they pivoted towards renewable energy, too much so really, and made some quite costly investments. They’ve pivoted back towards traditional fossil fuels, and that has led to some debate about what the right pace for doing that was, and they’ve had a couple of chief executive changes related to this pivoting that we’ve seen.

I’m not privy to exactly what happened in terms of the BP boardroom, but the observation I would make is the chairman briefly was an executive chairman because the company was without a CEO. And they have now got a CEO and maybe he struggled to get back to a non-executive spot. I don’t know.

Anyway, all I do know is that the senior independent director at BP is a lady called Amanda Blanc, who I know very well because she’s chief executive of Aviva (LSE:AV.), which is another share that we own, and if she felt it was right to move him on, then I’m happy to take her word for it. I’m sure in the full length of time, more details will emerge as to what was going on.

Why do we like BP? Well, first of all, we don’t own Shell (LSE:SHEL), so we’re not overweight in oil. We prefer BP over Shell. Why? Because it’s under-earning relative to either Shell or to its potential, because it’s had lots of change and invested all this capital in renewables. We haven’t yet got the benefit of coming back to the more traditional part of the business. 

It’s smaller, it’s more nimble, or should be more nimble than Shell, because the market cap is so big. So, those differences can make a difference. Only last year they announced the largest new oil discovery in 25 years, offshore Brazil, in a case called Bumerangue.

Those sorts of discoveries, having pivoted back towards exploration over time should manifest themselves in a better operating performance. Their operating performance is below where it should be from a margin point of view, their costs look elevated relative to their revenues and so forth. So, there’s quite a lot of change going through.

• Sector Screener: do BP shares still have investment potential?
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

We have got a new chief executive [Meg O’Neill] and I think this is her agenda and I expect to see a significant improvement in the operating performance at BP. It seems to always attract an awful lot of media attention, and it’s attracted even more than normal because of the events of recent years. But at its core, this is an under-earning business.

One other point I would make, is they still own 20% in a business called Rosneft, which of course is the largest oil company in Russia. Of course they have not been able to do anything with that stake while Russia has been under sanctions. At some point, the war in Ukraine will probably end and in which case they will have a 20% stake that might be worth 10% to 15% of their market cap that people have completely forgotten about and that’s just an extra degree of upside which people aren’t even thinking about as we sit here today.

Kyle Caldwell: Financials is a key area of focus and you mentioned that you have around a third of the fund in that sector. It’s been a strong couple of years for certain areas of that sector, particularly the banks. How are you now approaching investing in financials?

Clive Beagles: That’s absolutely right, but particularly the banks. I mean, some of the banks, as you know, stocks like NatWest Group (LSE:NWG) are up four or fivefold from where they were two or three years ago. I think we have to remember that that starting period, many people viewed banks as uninvestable. 

Why did they think that? Because their view was very coloured by the previous decade. We’ve gone through 10, 12 years ever since the financial crisis and then Covid where interest rates effectively were zero. It’s very hard for a bank to make a normal return when interest rates are zero because you can’t make a spread between what you’re paying a depositor or what you are paying someone to borrow money off you. It has only really been in the last two or three years that a cost of money has been re-established.

We’ve now got a yield curve that looks something more like what resembles what we’ve seen in most of the last 100 years. So, really, this phase has been about banks getting back to normal levels of profitability.

The question now is, are they over-earning or not? Some people would argue that they are because, for example, the level of bad debts is very low today relative to their history, but that’s because they’ve hardly done any new lending for the last five years. 

There’s not much other than individual little areas like private credits. There’s not much lending to go bad incrementally. So, we don’t think they’re over-earning. So, we’ve remained quite overweight banks, but what we have done is changed the mix between our names because one or two stocks have moved more aggressively than others.

NatWest had a very good move. We sold that about a year or so ago. We’ve introduced a new bank, which is just about to enter the FTSE 100, Investec (LSE:INVP).

Why are we interested in Investec? Because the valuation of that bank looks like the UK banks did two years ago. Why is that? Because it’s a weird company that’s half listed in the UK and half listed in South Africa. South African investors think it is a UK stock, and UK investors think it’s a South African stock. So, it almost feels like no one owns or even considers owning the shares. So, that’s what we’ve done. We’ve rotated around. 

Then I mentioned earlier an area of financials we’ve been adding to is real estate. It’s a very different dynamic in terms of what’s making real estate shares go up and down. 

Obviously, they’re very much more interest-rate sensitive in terms of where the bond yield’s moving, where interest rates are moving. But that would be the area [where], incrementally, we’ve be introducing greater exposure within our broader financials bucket.

Kyle Caldwell: Clive, thank you for your time today.

Clive Beagles: Thank you.

Kyle Caldwell: That’s it for our latest Insider Interview. For more videos in the series, do hit the like button and also the subscribe button. Hopefully I’ll see you again next time.