Why UK bank share prices should be higher

Nick Shenton, co-manager of Artemis Income, tells interactive investor’s Kyle Caldwell how the fund aims to grow its dividends, have a market-beating yield and outperform in total return terms.

Shenton also explains why sentiment is starting to change for the “unloved” UK market, makes the case for the area he invests in versus going global for income, and points out that UK banks is a sector that he finds himself “scratching his head” over as share prices fail to reflect the amount of surplus capital the companies have.

Artemis Income I Acc is one of interactive investor’s Super 60 fund ideas.

• Invest with ii: Buy Global Funds | Top Investment Funds | What is a Managed ISA?

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today in the studio I have with me Nick Shenton, co-manager of the Artemis Income fund. Nick, thanks for coming in today.

Nick Shenton, co-fund manager of Artemis Income: Kyle, it's great to be here. Thanks for having me.

Kyle Caldwell: So, Nick, over the past five years, the fund is top quartile in its sector, which is the Investment Association's (IA) UK Equity Income sector. What have been the key performance drivers?

Nick Shenton: Two things, really. Stocks. The companies we invest in, the shares have gone up. So that's been helpful, obviously. That's what we do. It's our bread and butter.

The second thing we think is really important is the portfolio. The fund has been able to transition between two radically different environments.

With a curveball, if that's not mixing metaphors, in between a Covid. So, we had quantitative easing when interest rates were very low. Then we had Covid, and now we've got inflation. Very different environments.

But the fund has been able to navigate that through being diversified and through really thinking about the investment backdrop. It's not good enough to say when the going is good, oh yes, we're doing well, and then when it's not to say, oh, but the markets are being unfair. We've just got to make money in different environments and we've done that.

Kyle Caldwell: The fund is aiming to grow its dividends, beat the market in total return terms and also have a market-beating yield. How do you put all that together?

Nick Shenton: And let's also say we've got to do it in a cleaner way than the market on average from an environmental, social and governance (ESG) perspective, so it's not too much to ask. We think about it really simply, we're simple folk. We find that you've got to go through a lot of complexity to get simplicity, and that's when you're on to something.

So, we look for around a 4% dividend yield growing at 5%. And if we can deliver that, we think that's a really attractive investment proposition. Regardless of where you invest, we think that stacks up really well versus global equities. We think it stacks up well, versus different asset classes and compounding at 9%, which is what the fund has done, net of fees, give or take, over 24 years, means that you go from £1,000 invested at inception being worth over £7,500 now.

So, we think if we do that and we've got the process behind it, then we'll compound people's capital. And you're right, we think about this as wealth creation. We think about this as total returns. We invest and certainly, Emma, my wife, and I invest all our spare pennies in the fund, that's what we're looking for.

• Watch our Artemis Income video: three cheap UK shares and a ‘magic bean’ investment
• Sign up to our free newsletter for share, fund and trust ideas, and the latest news and analysis

Kyle Caldwell: The UK stock market has been unloved for several years now. What needs to happen for that to change? What needs to happen for fund flows to turn positive once again for UK equity funds?

Nick Shenton: It'sa really fair point, but here's the thing about financial markets; trees don't grow to the sky. By that, what I mean is that valuations only go so far and at some point capital flows from more expensive businesses into cheaper ones because the prospective returns are better.

Yes, the UK has faced a lot of headwinds. Yes, it has been unloved. We still think there's some outstanding businesses here. The reality of what it will take to change that is really a different perception. And that perception would come from international investors.

There's a couple of things we see that we think are really interesting. We see flows away from active management to passives, and that's understandable. Passives and index funds and exchange-traded funds (ETFs). It's incumbent on us to create value, not just by tracking an index. It's about stock picking and risk management, that's what we've got to do.

So, there's been structural pressures there and we've seen capital flow overseas. But these two very interesting things are happening. First, we're seeing that capital come back, so the money that's been leaving the UK, going to the US, we are seeing US investors show up in the UK, and they're showing up in size because they can see value, we think.

And when Capital Group, who we respect a lot, and Fidelity and Causeway and WCM and all these big US businesses, when they show up in the UK, they move share prices, and they are showing up and you can see that in Sage Group (The) (LSE:SGE), you can see it in Next (LSE:NXT), where Capital has just taken 5% of the company in a few months, and that to us is a signal of value.

And then the companies themselves are saying, well, if you won't buy our shares, UK public, we'll buy them ourselves. Over 60% of the portfolio by value is bought-back shares in the past year. And we're on that ticket. If we're patient shareholders, we think we'll end up owning the businesses through the golden share because all the other shares will have been bought back, so something has to change. But the interesting thing is it is changing. We can see it in the market. We can see and feel it.

Kyle Caldwell: One sector that's benefited from money leaving the UK is global equity income funds. Could you make the case for investors to return and to pick a UK equity income fund like the one you manage over going global?

Nick Shenton: Well, they both have a role in portfolios we would say. Something that we slightly scratch our heads on from a first-principles perspective is that surely, if you're saving for retirement, you want to be saving in the currency that you're going to retire in? The US is an amazing country, an amazing wealth-creating society, but maybe it's a bit risky to be putting all your assets effectively into US dollars when you've got two, frankly, inflationist presidential candidates? So that we don't quite understand necessarily.

Of course, it does make sense to diversify and to invest overseas. What we would say currently is we think there's a lot of value in the UK that's been created by that trend. People have sold the UK in a price-insensitive manner to go global. Then that's created an opportunity in the UK because valuations are cheaper and valuations are cheaper in the UK versus pretty much every other stock market.

And how does that manifest where you get a higher dividend yield? So you're dividend yield is close to 4 in the UK, which is significantly in excess of what you get investing globally. But as we say, we think it makes sense to have both strategies. Just to us, the value looks more apparent in the UK. There are some outstanding businesses in the US, but going overseas is largely going to the US, and within the US it's largely going to tech.

• Where to invest in Q3 2024? Four experts have their say
• Funds and trusts four pros are buying and selling: Q3 2024

Kyle Caldwell: You mentioned earlier that the fund aims for around 5% dividend growth per year. Has that been achieved over the past decade?

Nick Shenton: It's been a challenging 10 years. If you go back 10 years, there was probably over-distribution and disruption. We were quite vocal on that, that companies need to reinvest more. Where we are today is we think that the competitive environment is the best it's been for probably 15 years for the type of businesses we invest in, and the dividend payout ratios are lower than they were 10 years ago. That's a good place to be.

The second challenge has been Covid, which rebased things. So, if you were to look from 2014 to 2019, the dividend grew about 7%, but then it got rebased during Covid. We actually worked with companies and said, don't pay dividends, build your liquidity, get through this intact.

So, over the past decade, the dividend growth has been lower, at around 3%. But we think the prospects are pretty good from here. It's very well covered by cash flow, and with companies buying back shares, you get growth from that too.

Maybe one of the best examples is Tesco (LSE:TSCO). It's around a 10% free cash flow yield. So, you get a 4% dividend yield and it's growing at 5% just from share buybacks. We think the prospects are pretty good from here.

Kyle Caldwell: As a fund, all the income that's generated by the underlying investments you return to investors each year. So, if there's less money coming in, then there'll be less dividends paid in a given year?

Nick Shenton: Yes. But what we see also is the opportunity from here is this reduction in share count. So, we're saying stick with us and your ownership of these companies will go up. Again, let's return to Tesco last year. We and our co-investors increased our ownership of Tesco by 5% without spending a penny - and that's from share buybacks.

What that means over time is the dividends will go up. So, the number of shares fall, the dividend per share goes up, and so that is one of the reasons we feel pretty constructive about the outlook for dividends and dividend growth.

Kyle Caldwell: In terms of sectors, are there any at the moment that particularly stand out for you that are increasing their dividends? Is the banking sector, for instance, an area that you're invested in? I think this year it's going to be a year-on-year increase for bank dividends.

Nick Shenton: Yes, it is, and it's also an area where we've been very closely engaged with management teams. We are genuinely active investors and we are fortunate with our access to companies. But because of the scale of Artemis overall in the UK market, we've got some very good fellow UK investors. We have good conversations with companies, and this point about share buybacks is one that we've really worked on with Lloyds Banking Group (LSE:LLOY), NatWest Group (LSE:NWG) and Barclays (LSE:BARC).

• UK bank results season: a preview and top stock picks
• ii Top 50 Fund Index: most-bought funds, trusts and ETFs in Q2 2024

We agree very simply that the banks had 10, 12 years of paying fines and building capital after the financial crisis - that's largely done - and now they have strong capital positions. They're very well regulated. We think they're very well run and they have surplus capital. The shares have been so cheap that they've been able to buy back large chunks of their stock, and that leads to increased value per share.

We think the really strange thing is that the share prices hadn't been reflecting that. We were almost scratching our heads wondering why share prices not going up more. Because when the share count goes down, the share price needs to go up. Otherwise, the value of the business is falling, which makes no sense. So, banks, we think, are well placed and they are quite key for dividends and dividend growth looking forward.

Kyle Caldwell: You've already touched on the answer to my last question when you mentioned that you and your wife have investments in the fund. Have you got anything further to add in terms of skin in the game?

Nick Shenton: Yes, we eat our own cooking. You'd never go to a restaurant where the chef wouldn't eat their own food. We think, why would you invest with a fund manager who doesn't invest in their own funds?

I'd say we're all in. We are partners at Artemis, Andy Marsh, Adrian Frost [the two other co-managers] and myself. We're very passionate about the business, about the culture, about what we do. We are very competitive people, so we care deeply about our investors and about producing the best returns for them. We have some investors who've been with us for over 20 years, and we take great pride in that.

I think when we look back at our careers, maybe the thing we'll be most proud of is that people trusted us. That's the most valuable commodity, trust. That people trust us with the future of their families, their savings. We take that very seriously, and then we invest alongside. So, Emma and I, everything we have that is spare, that isn't in our home, goes into investing in the income fund.

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

Nick Shenton: Thanks very much for having me, Kyle.

Kyle Caldwell: So, that's it for our latest Insider Interview. I hope you've enjoyed it. Let us know what you think. You can comment, like, and do hit that subscribe button for future videos. And hopefully, I'll see you again next time.