Why we cut back on banking shares

Henry Dixon, lead manager on the Man Income Professional Acc C fund, talks about his “contrarian” decision to moderate his exposure to banks after a run of strong performance.

He also makes a case for how the fund stands out versus other value-minded UK funds, and talks about the sectors that have started to catch his eye.

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Dave Baxter, senior fund content specialist at interactive investor: Hello and welcome back to our Insider Interview series. I’m Dave Baxter and joining me today is Henry Dixon, lead manager on the Man Income fund. Henry, thank you for joining me for today. 

Henry Dixon, lead manager on the Man Income fund: Thank you for having me.

Dave Baxter: So, Man Income has had a good run in the last few years, but it’s one of hundreds of UK equity funds out there. What actually makes you different from the competition? 

Henry Dixon: So, I’d probably, at a high level, highlight three things. First is the yield premium on offer from the fund. I think we target something that is 20% to 25% higher than the market yield. So, that can be helpful, particularly for those clearly looking for the income.

The second point is around the distribution of the income. We’re very happy to distribute it monthly to our clients and I think they appreciate that monthly revenue stream coming in from their investments.

And then third, I think it’s the contrarian value approach that can hopefully [say] the target and that has been the case over the last three years has been outperformance versus the reference benchmark, which hopefully puts it towards the top for the pay group. 

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Dave Baxter: So, let’s talk about that contrarian value focus. If I look at the performance tables over recent years, many of the top-performing UK funds do have a value bias. What’s different about your value style? 

Henry Dixon: Within value, the key things that we’re trying to target is certainly long-run value measures, be it invested capital, and we’re looking at returns on capital. So, that’s really how we would try to define value.

However, it’s important to have awareness of other factors which are really important for equity returns. For example, within the quality aspect of investing, we’re absolutely determined to try and isolate some of the best balance sheets, because I think balance sheet strength is absolutely crucial. We define that as low debt, but also high free cash flow yields. Finally, within momentum, the momentum aspect that we’re most keen to incorporate in the fund is earnings momentum

Put simply, if we can construct a portfolio that’s cheaper than the market with a better balance sheet than the market and positive earnings momentum, then that is statistically a very strong bedrock for future outperformance. 

Dave Baxter: Value investors have coalesced around areas like financials, that kind of thing. Are there any particular names that you would identify in the fund as being more contrarian, a bit different? 

Henry Dixon: A few years ago what seems quite mainstream now was very definitely contrarian, but certainly three to four years ago financials themselves were very contrarian, but we had a huge change in the interest rate narrative and that precipitated some very strong returns.

Something that we did towards the back end of last year was that we actually got ourselves underweight banks just at a time [when] they were becoming very fashionable. I think that was to some extent quite contrarious. Where we’ve gone with those proceeds, I think, is other areas of the market that find themselves on half book value, which is absolutely where the banking sector found itself three to four years ago. 

We’d highlight areas such as real estate, for example. I also think we moved quite early on mining last year. We had some really good nascent signs of earnings momentum coming from some very good long-run valuation measures. So, that’d be another area that now feels quite mainstream, but certainly in the moment, six to nine months ago, felt quite contrary.

Dave Baxter: And is that underweight in banking a valuation-led move or...? 

Henry Dixon: It is in the main valuation led. There are pockets of opportunity, certainly. But if I think about where banks have gone over the last four years, it’s from half book to the best part of two times book in certain cases for some of the mainstream UK large-cap banks.

That to us feels like the top end of expectations for valuation. I still think there is opportunity within banks. We very much like the Irish sub-sector, for example, so we’re drawn to what are some of the highest capital ratios in Europe within the Irish banking sub-sector. We also think that there’s a very conservative assessment around risk weights, so that’s essentially saying that the marks they take on their assets are very conservative, and that can again drive this great confidence in the excess capital position we think we see within the Irish banking sector. 

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Dave Baxter: By now, we’re very used to hearing about the fact that managers think UK shares are undervalued, but we have seen a big rally in recent years. So, in that context, what is still cheap to you and where are you a bit more concerned about valuations? 

Henry Dixon: Yeah, so quite a bit to discuss there. Certainly it’s welcome that the UK market has started to perform a bit better. It’s done it in the face of pretty poor sentiment and continued outflows. So, I think the value argument has really started to bear fruit, driven by attractive dividends, and also the move to share buybacks, which has really catalysed some share prices.

What I would say with regards to the performance, which in keeping with some other indices around the world, is that it’s been really quite concentrated in just a few names. So, that concentration, by definition, means that there is quite a big opportunity in the areas that just haven’t participated to any degree

We look at some marked-out performance of some of the larger-cap companies in the UK, which I think have left opportunities presenting themselves lower down in the market cap spectrum in the FTSE 250 and in the small-cap arena. That’s certainly where we’re starting to take our proceeds. For example, I mentioned in banks and we’re starting to try to rotate into opportunities in that area of the market. 

Dave Baxter: Can you give me some examples that are standing out from the small and mid-cap space? 

Henry Dixon: What I’d talk to is a few sectors and ideas within those. So, I mentioned moving to some real estate. As an extension of real estate, I will also look at some of our construction names in the UK being on valuations akin to where we saw them during the global financial crisis.

The environment out there isn’t necessarily completely straightforward, but nor do I think it’s anywhere near quite as difficult as it was during 2008 and 2009. Those type of valuation benchmarks look to us to be good opportunities for us to be trying to capitalise on.

The other area that we’d take on, with slightly sticky inflation in mind and maybe interest rates staying higher for longer, is some of the financial sectors. They look very interesting to us. It’s possible for us within specialty financials to find trading businesses trading at nearer 10 times earnings, net cash on balance sheet, very positive earnings momentum. I do think the trading outlook for those businesses given the volatility continues to be pretty favourable. 

Dave Baxter: Yeah, and what examples are there from...you talk about leaning into the small and mid-cap space? 

Henry Dixon: So, further to real estate, I’d certainly single out some of the construction names within the UK, which I still think have a similar asset theme, namely within the house building sector and the RMI (Repair, Maintenance, and Improvement).

We can look at valuations today, which were akin to where they were in the global financial crisis. I’m not absolutely pretending it’s easy out there at the moment with sticky inflation, and maybe a more mixed economic outlook, but I think definitely where we can find valuations that stack up against that period 2008-09, then I think we’ll be well rewarded if we take the other side of that opportunity.

Other areas with inflation staying high would also be interest rates maybe staying higher for longer. So, that brings in some of the areas of financials. We can definitely find some trading businesses within financials at near enough 10 times with excess cash on balance sheet and enjoying positive earnings momentum. As I say, that interest rate backdrop, I think, will lead to a positive earning momentum sticking around for longer than people anticipate. 

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Dave Baxter: How much leeway do you tend to give when you get shares with either low or no yield? I noticed, for example, that AstraZeneca (LSE:AZN), the biggest name in the index, doesn’t seem to feature in the fund or at least your top holdings list. 

Henry Dixon: Yeah, so we’re absolutely not afraid of having no weight in large constituents within the index. It’s important to have that active approach and if they don’t meet the yield criteria, then it’s appropriate that we aren’t weighted. 

That being said, we do have a portion of the portfolio that we specifically target in dividend growth. Here, we’re trying to isolate strong balance sheets as defined by net cash and also excess free cash flow yields. The hope is if we can marry up those two aspects then we can isolate dividend surprise or unleash shareholder return surprise. It might come in the form of a buyback, but that will be well rewarded with regards to capital upside. 

Dave Baxter: Henry, many thanks for your time.

Henry Dixon: Thank you.

Dave Baxter: And thank you everyone for watching. We hope you enjoyed the video. Do let us know what you think in the comments. And as always, if you’re enjoying this series, hit the like button and the subscribe button. Take care.