Liontrust Income Fund

The Liontrust Income Fund returned 1.1% over the third quarter of 2021, versus the FTSE All-Share Index’s 2.2% and 2.3% from the IA UK Equity Income sector average (both comparator benchmarks)*.

UK equities started the third quarter well, bolstered by strong second quarter earnings reported across the majority of sectors.  As we entered the quarter, earnings revisions ratios for UK companies reached fifteen-year highs, indicating that UK companies had weathered the Covid storm better than many had feared. This earnings momentum injected a degree of optimism into the market, as did the restoration of UK dividends, which have recovered to one sixth below pre-Covid levels.

Since September, however, along with other global markets, we have seen the majority of these gains erased. Central to this observation has been the pace of inflation (which climbed to 3.2% in August), closely tied to the direction of interest rates and bond yields, and consequent valuation support for equities. In the past month we have seen a sharp rebound in UK bond yields, which surpassed 1% for the first time since May 2019 as the Bank of England took a more hawkish stance on monetary policy to combat inflation. Companies across the industry spectrum continued to report cost inflation pressures, citing supply-chain bottlenecks caused by the disruption of the pandemic. 

Adding to recent uncertainty, the regulatory crackdown in Beijing on companies on the wrong side of the theme of ‘common prosperity’ has created concerns beyond China, given the region’s critical importance as both manufacturer and end consumer for many multi-national companies. In the UK, the prospect of lower Chinese growth hit both Asian exposed banks and mining stocks hardest. 

Energy was the top performing sector over the quarter as oil and gas prices edged higher, in part aided by the widely publicised shortage of fuel and natural gas. Healthcare and technology also held up well, while Industrials benefitted from a resumption in economic activity. Materials (dominated by miners in the UK), underperformed as the possible collapse of Chinese property developer, Evergrande, highlighted a potential slowdown in construction activity. 

M&A activity continued apace; year to date we have witnessed near 90 deals worth over £200bn in the UK, with strategic and financial buyers alike attracted by the relative valuations of UK assets. Notably, Q3 featured a private-equity bidding war for Wm Morrison Supermarkets, as well as US domiciled DraftKing’s proposed intent to acquire Entain within sports betting. For the most part, though, M&A has been focused on smaller and mid-size companies, which has been a tailwind for FTSE 250 performance. 

The “three silos” we use to construct the Fund are intended to help mitigate any value or growth style bias in the market by performing at different stages in the market cycle. Whilst ‘growth’, ‘value’ and ‘quality cyclicals’ outperformed at various stages throughout Q3, there was no net style bias in any particular direction, and as a result there was no standout silo for the quarter. There was notable dispersion within sectors, but ultimately it was individual stocks, with their own stock-specific  influences, which were the driving force behind fund and sector performance over the period.

On a sector basis, key contributions to Fund performance stemmed from our overweight to technology stocks, namely in the US, where we utilize of our permitted oversees exposure. A rotation back towards growth names lifted mega-cap tech names, though this tapered off somewhat by quarter end as real rates began to rise. Our relative underweights to communication services and consumer staples also served us well, as both sectors saw stocks falter through the quarter. On an individual company basis, key contributors included Diageo, which welcomed the return of ‘on-trade’ drinking; BAE Systems, rendered a beneficiary of Australia's decision to utilize UK nuclear powered submarines, and RELX, which continued to see growing demand for B2B analytics and improved recovery prospects in their events business. 

Notable detractors to performance stemmed from our relative overweight positions in materials and financials, and our underweight position in consumer discretionary. Within materials, our mining stocks struggled as commodities (especially Iron Ore) took a major hit off the back of Chinese regulation and the Evergrande debacle. Meanwhile, Johnson Matthey was a victim of global chip shortages and the subsequent slowdown in automobile manufacturing, which had the knock-on effect of reduced demand for auto-catalysts. Financials were hindered by a couple of underwhelming stock-specific updates, notably from M&G who saw strong capital generation but weaker-than-expected flows. In the consumer discretionary space, our homebuilders struggled on wavering sentiment as the end of the stamp duty holiday loomed, but strong fundamentals enabled boosted shareholder returns via dividends.

It remains a challenging environment to make assertions about the future, given supply chain disruptions and the continued tenacious nature of Covid in its varied forms. Nonetheless, the macro environment is still broadly improving, and the Bank of England has maintained their (recently increased) GDP growth target at 7.25% for 2021. Inflationary concerns do remain salient in the market, as evidenced by continued rising costs of materials and labour, and could lead to rate increases from the Bank of England as soon as the start of next year. This backdrop should continue to favour companies with strong pricing power, as well as those for whom rising rates proves a tailwind.

We see good reason to remain optimistic about the UK income space and the Liontrust Income Fund’s positioning within it going forward. As a Fund that is fully invested in dividend-paying companies, the widespread cuts last year meant that our investible universe effectively shrunk. We are now starting to see a reversal of this trend; 2021 dividends are expected to grow by 13.4% year-on-year on an underlying basis (i.e. excluding special dividends) to total near £70 billion, or closer to £80 billion including specials. It is worth remembering that total pre-crash underlying dividend pay-outs were over worth £100 billion, so we see plenty of scope for dividend pay-outs to continue to ramp-up over the coming years.

Additionally, the UK – and the FTSE 100 in particular – is trading at a historic discount to itself and global peers. Whilst not particularly novel, this valuation gap has widened in recent months, at a time when UK companies have seen a notable upward revision in earnings, and as major macro headwinds have started abating thanks to Brexit clarity and the vaccine roll-out. This creates a fundamental value opportunity in the market, one which the Liontrust Income Fund (owing to our skew towards larger-cap stocks) is well positioned to take advantage of going forward.

Our portfolio remains well positioned towards future dividend growth, and for 2021 we are expecting a slight increase in our dividend payout from last year.

Discrete years' performance (%)**, to previous quarter-end:

*Source: FE Analytics as at 30.09.21

**Source: FE Analytics as at 30.09.21. Quartiles generated on 06.10.21.

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