Income investing: do ‘cheap’ UK shares trump going global?

In recent years UK investors have shaken off any residual loyalty to their home market, instead steering capital into global funds. The UK’s wayward politics, weak currency and sluggish growth have all been active deterrents, alongside more appealing growth options overseas. However, the UK may be turning a corner, and may merit another look for income investors.

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The logic of looking globally for income was sound. In the UK, income was concentrated in a handful of staid companies in unlovely areas such as banking, mining or energy. Looking further afield brought in faster-growing markets. It also brought in more exciting sectors, poorly represented in the UK, such as technology.

The slide in the UK’s popularity has been stark. Over the past decade, the global equity income sector has grown from £9.8 billon to £22.2 billion, while the UK equity income sector has slumped from £70.7 billion to £33.6 billion. It is a similar picture for the global sector versus the UK All Companies sector: the global sector is up from £69.6 billion to £163.2 billion, while the UK All Companies sector has dropped from £136.2 billion to £131 billion.

Those investors that have made the switch have been rewarded. Over 10 years, the average Global Equity Income fund has grown 117%, while the average UK Equity Income fund is up just 55%, according to FE Analytics. Investors in global equity funds have sidestepped the difficulties around the Brexit vote, the UK’s political and economic volatility, and the resulting unpopularity of the UK market. They have also been able to tap into fast-growing trends: the growth of semiconductors, digitisation and the emerging market consumer.

Has tide turned in favour of UK equity income?

However, the question today is whether the move has gone too far. The UK is now cheap on almost any measure – price to earnings, dividend yield, price to book. Its larger companies are global, and look cheaper than international peers doing much the same thing. John Monaghan, research director at investment consultancy Square Mile, says: “A lot of managers believe that valuation will win out in the end. The UK has a lot of international-facing companies, so investors are getting global exposure from companies that are attractively valued. It also has a good income profile and investors don’t have direct currency issues.”

James Sullivan, head of Tyndall Partnerships, says: “If we consider that over the past five years, the FTSE 100 price earnings ratio has derated by some 22% against an MSCI World ratio that has rerated by 27%, the swing factor is very meaningful. That means today, the current trailing price to earnings ratio on the FTSE is over 30% lower than its own 12-year average and 45% lower than the current MSCI World. Putting ‘whataboutery’ to one side, the UK is very cheap.”  

However, markets can remain cheap for some time. Investors may need another catalyst to be tempted back to their home market. This may come from the end of a tumultuous period for the UK economy and its politics. While UK fund managers will argue that the UK market is global, and that the UK economy is therefore of little relevance, its difficulties have undoubtedly weighed on sentiment. Some stability appears to be returning to UK politics and its economy. While it remains unexciting, its performance is no worse than many of its European peers.

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Moreover, the UK corporate sector is generally in good health and UK companies have sufficient confidence to invest in their own stock through share buybacks.

Value characteristics

The UK can also provide a good ballast in a portfolio, which have become increasingly growth focused as technology has outpaced other sectors. Sullivan says: “2022 reminded many of the importance of diversification, not just between equity and bonds, and US and the rest of the world, but also value and growth. A UK Equity Income fund is laden with value characteristics, which if unlocked, are extremely rewarding.”

Alex Funk, chief investment officer at Schroders, believes this may be a moment for more value-focused strategies: “Maybe we won’t get this big recession, but there is still a version of a slowdown coming. After a 5% hike in interest rates, earnings can’t compound as they did before. The UK market is traditionally defensive, low beta and ticks a bit slower than a high-tech growth market.”

In this environment, the higher income available from the UK market may have more appeal. Funk says: “If an investor thinks growth will be lower, but dividend yields are 5%-6%, that becomes more interesting. Dividends provide a more predictable cash flow. Right now, there’s too much euphoria around growth and the prospect of a soft landing. As it fizzles out, reallocation will start to happen.”

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Funk likes funds with more cyclical exposure, which could benefit from a recovery. These are funds such as the JOHCM UK Dynamic. For small and mid-cap exposure, he has an allocation to the ES R&M UK Listed Smaller Coms fund.

Concentration conundrum

Nevertheless, some of the residual problems of UK equity income funds remain. Income still comes from a relatively narrow range of companies and sectors. The latest UK Dividend Monitor from Computershare shows that 34% of UK dividends are concentrated in just five companies – Glencore (LSE:GLEN), Shell (LSE:SHEL), Rio Tinto Registered Shares (LSE:RIO), HSBC Holdings (LSE:HSBA) and National Grid (LSE:NG.) – while 65% are in the top 15 dividend-paying companies.

For Sullivan, one way to deal with this is to look for funds that invest across the market cap spectrum. He says: “The best value appears in the mid and small-cap arenas. WS Gresham House UK Multi Cap Income, launched in 2017, has handsomely outperformed the FTSE All-Share over that time, while delivering a yield consistently north of 4%. The portfolio of companies straddles the FTSE 100, FTSE 250 and FTSE Small Cap, therefore there is a big element of domestic exposure, where the best value lies.”

Monaghan points out UK funds are allowed to hold up to 20% in overseas assets. Some investment trusts go one step further – the Dunedin Income Growth (LSE:DIG) Investment Trust has 25%. “Lots of them use this facility,” he says. He sees it used to diversify from UK healthcare provider AstraZeneca (LSE:AZN), now a large part of the index, or to take exposure to sectors poorly represented in the UK index – “Microsoft Corp (NASDAQ:MSFT) features quite frequently”, he adds.

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In this way, the UK offers a choice of yield options. Monaghan says for investors who want to start off with an attractive yield Schroder Income or Man GLG Income may fit the bill.  

The case against UK equity income

The counterargument is that the UK is still an unpopular market, forms just 4% of the MSCI World index and may continue to be overlooked by investors. The country struggles with a productivity problem and weak sentiment has pushed some companies to list elsewhere, creating fragility in its capital markets. If one of the arguments for the UK is that it is global in nature, why not just pick a global fund, bringing greater choice and diversity?

Global funds still bring exposure to new and higher growth areas not available from the UK market – emerging markets, technology, luxury goods. Funk chooses the Schroder Global Sustainable Value or Fidelity Global Dividend funds, while Monaghan likes the Guinness Global Equity Income fund, but also the TM Redwheel Global Eq Income fund, managed by Nick Clay, and the M&G Global Dividend fund.

The arguments for an allocation to UK equity income are stronger than they have been for some time, particularly as a counterweight to a high  “growth” exposure, built up over a decade. However, the UK still has its limitations and its recovery is not assured. It may be sitting on the fence, but a balance between the two would seem like the best option in uncertain times.