Guest Spot from Octopus: New fund and new Dad – what have I learnt over the last three years?

Chris-McVey_Octopus-Investments_Headshot
  • Author : Octopus Investments
  • Date : 7 Dec 2021

Over three years, FP Octopus UK Multi Cap Income Fund tops the IA UK Equity Income Sector. What’s the secret to its success? Chris McVey, lead fund manager, explains his approach and what it can offer investors.

Three years ago, we launched an equity income fund with a difference.

The fund launched at around the same time as I had my first child. Managing a young fund arguably has some parallels with having a young child. Both need constant attention, and both will take time before their personality becomes fully formed.

Whilst the fund, thankfully, has not demonstrated any of my two-year-old daughter’s temper tantrums, since day one, we have had some incredibly challenging market conditions.

Our idea was simple – to construct an equity income product that was capable of delivering better than market earnings and dividend growth through the cycle.

We felt this would be best achieved by leveraging our team’s capabilities and expertise to take a multi-cap approach to portfolio construction. We focus on faster growth, progressive businesses, and avoid packing the fund with many of the same low growth, often ‘sunset industry’ stocks you’ll find in most traditional UK equity income funds.

Brexit negotiations continue to rumble on, whilst a global pandemic has added to the mix. Extreme market volatility, uncertainty and widespread dividend cuts set have all added to the fun.

Less than ideal conditions for a fledgling fund. So how did it perform?

In the three years since it launched, FP Octopus UK Multi Cap Income has returned 69.8% placing it 54.0% ahead of the FTSE All Share and 53.5% ahead of the average fund return within the IA UK Equity Income sector.[1]

How was this achieved? When looking to develop this strategy we identified three key risks potentially impacting a significant proportion of the rest of the UK Equity Income sector.

Significant holding concentration across many of these ‘traditional’ equity income funds, low dividend cover amongst many of these holdings, and low potential growth. Our multi-cap strategy was developed to mitigate some of these concerns and offer investors true diversification when considering their UK Equity Income options.

So far, the fund has delivered outperformance against the wider IA UK Equity Income sector just as we would have hoped.

Too many eggs in one basket

Ten of the biggest FTSE 100 companies make up more than half of all UK dividends. [2]

If you look at most traditional UK equity income funds, they’ll usually hold many of these same stocks.

This concentration could be a big problem for investors.

Firstly, you’ll be very exposed to the performance of just a few companies. And secondly, holding multiple income funds to provide diversification is unlikely to have the desired effect.

Whichever way you cut it, the chances are you’ll remain over-reliant on these few large companies. If these companies don’t perform, neither do the funds you hold.

You might be wondering, then, why all these funds are holding the same stocks. The answer is obvious. These income stocks pay out a large proportion of their earnings as dividends. In our view many of these companies were over-distributing over recent years. But what happens when they don’t?

Big dividends are rarely matched by earnings growth

Some of these stocks are popular with investors largely because they can pay out chunky dividends – not because of their exciting growth dynamics.

These companies also know their investors typically hold shares specifically for the dividend, meaning they will focus on maintaining, or even growing it a little each year.

And while the average dividend per share growth has been strong for the ten largest FTSE 100 stocks pre Covid at more than 12%, what was concerning us was that the average earnings per share growth for the same companies over this period has been a meagre 3.3% per annum.[3]

Without growth in earnings, it’s harder for a business to sustain increases in dividends indefinitely. It’s also more likely that such a company might need to cut its dividend in the event of a shock.

This was exactly what we saw with the pandemic, with many traditional UK income stocks cutting their dividends, with pay-outs falling by 44% in 2020.[4] Whilst these dividend pay-outs are now recovering from these low levels, we think that these stocks won’t be able to reinstate dividends back to pre-crisis levels any time soon.

The multi cap approach

The good news is there’s a way to limit your exposure to these big income stocks, without compromising on targeting an attractive and growing income stream.

The Octopus Quoted Companies team is made up of 9 investment professionals with a long track record of investing in UK small and mid-sized companies. We look across the entire UK equity market and don’t just focus on the big traditional income stocks. Taking this approach, means investors should benefit from a progressive equity income stream that’s capable of better than market growth through the cycle.

Smaller and mid-sized companies can lie in a sweet spot of earnings growth, underpinning progressive dividend growth. Whilst the fund has around 25% of its holdings in companies larger than £1 billion, we have found that UK companies valued above £100 million, but below £1 billion, are often on a steady growth trajectory and can pay increasingly attractive dividends. These companies are the focus of our fund, despite them being largely overlooked by most traditional UK equity income funds.

We take a fundamental, bottom-up investment philosophy to portfolio construction and meet over 850 companies a year to identify the best investment opportunities.

The average tenure of our team is 12 years, and we manage over £2.9bn[5] across AIM VCTs, AIM Inheritance Tax products as well as three funds: FP Octopus Multi Cap Income, FP Octopus UK Micro Cap Growth and the recently launched FP Octopus UK Future Generations fund. And, like three years ago, I have also just had my second child…

Investing in smaller companies can carry more risk

The value of an investment, and income from if, can fall as well as rise. Investors may not get back the initial amounted invested. While smaller companies can offer benefits for an equity income portfolio, you must also consider the additional risk this involves.

Please remember that investing in smaller companies can involve greater risk than may be associated with investing in larger, more established companies.

The share prices of smaller companies can fluctuate more in value than their larger counterparts. The shares may also be harder to sell.

Investment approach – Core and Satellites

As with the other OEICs, the fund utilises our “core and satellite” approach to portfolio construction.

The core is made up of companies that we believe can grow earnings and dividends ahead of the market. We look for robust finances, superior prospects for profit growth, appropriate balance sheets and good earnings visibility.

The satellite positions are designed with two key attributes in mind – income or growth.

The income satellites are those companies potentially delivering superior, sustainable dividends albeit with lower near term growth characteristics.

Whilst the growth satellites are expected to demonstrate exceptional growth opportunities albeit with lower near term dividend expectations.

Our fund isn’t constrained by investing in any one part of the market. Instead, we look at every company and ask:

  • Can it offer a dividend yield greater than the wider market?
  • Can it deliver faster than market earnings growth?
  • Can it deliver faster than market dividend growth?

Asking these questions helps unearth potential income stars of the future, long before other income funds would consider them. The key point is that each holding provides at least one of these three characteristics.

This focus has enabled us to develop a portfolio which has delivered better than market capital performance, coupled with an attractive and growing dividend yield. Hopefully, this can continue.

As always, past performance can’t be used as a reliable indicator for future performance. However, we believe the fund with its solid and differentiated investment process, delivered by experienced management, will continue to deliver impressive risk-adjusted returns.

Here’s a closer look at three great companies in the portfolio:

  • Core       MJ Gleeson    

 We were attracted to the business by its unique market positioning, its fantastic customer economics, and its obvious social benefits of providing quality low-cost homes in areas of economic regeneration. We believe the group has excellent long term growth prospects and, in our view, this will be a considerably larger enterprise within our Core 3 to 5 year investment horizon. The stock also benefits from a solid and growing dividend.

  • Satellite Income       Urban Logistics

 The UK’s only listed ‘pure play’ business solely focussed on ‘last mile’ urban, high quality logistics properties enabling tenants to operate the essential modern distribution networks demanded by e-commerce. It has terrific dividend potential and well as capital value appreciation in an asset class that we suggest is increasingly seen as core UK infrastructure and should be valued as such. 

  • Satellite Growth       Next 15

 A specialist communications and marketing services business, driven by technology and centred on the technology of marketing: data, insight, analytics, apps, content platforms and content itself. This is currently one of our largest positions having demonstrated excellent growth characteristics with several positive recent trading updates. We believe this stock remains extremely well placed.

The mention of stocks is for illustrative purposes only and should not be seen as an investment recommendation.

We remain upbeat about the prospects for the fund and I’d like to thank everyone who has invested with us so far.

Risks to bear in mind

The value of an investment can fall or rise and you may not get back the full amount you invest. Smaller company shares are also likely to fall and rise in value more than shares in larger, more established companies listed on the main market of the London Stock Exchange. They may also be harder to sell.

Our investments are not suitable for everyone. We do not offer investment or tax advice. Personal opinions may change and should not be seen as advice or a recommendation. Before investing you should read the Prospectus, the Key Investor Information Document (KIID) and the Supplementary Information Document (SID) as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The Prospectus, KIID and application forms are available in English at octopusinvestments.com. The Authorised Corporate Director (ACD) of these funds is FundRock Partners Ltd which is authorised and regulated by the Financial Conduct Authority no. 469278, Registered Office: 8/9 Lovat Lane, London EC3R 8DW. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London EC1N 2HT. Registered in England and Wales No. 03942880. November 2021. CAM011582

[1] Past performance is not a reliable indicator of future results. Source: Lipper to 26/11/21. Returns are based on published dealing prices, single price mid to mid with net income reinvested, net of fees, in sterling. Investment Association performance represented by the average fund performance of respective IA total return sectors.

[2] Source: AJ Bell Dividend Dashboard 30/06/21

[3] Source: Factset, 24/06/21

[4] Source: Citywire, 28/09/2021 ‘Investors lose appetite for UK Equity Income’

[5] Source: Octopus 31/10/21

Risks to bear in mind

The value of an investment can fall or rise and you may not get back the full amount you invest. Smaller company shares are also likely to fall and rise in value more than shares in larger, more established companies listed on the main market of the London Stock Exchange. They may also be harder to sell.

Our investments are not suitable for everyone. We do not offer investment or tax advice. Personal opinions may change and should not be seen as advice or a recommendation. Before investing you should read the Prospectus, the Key Investor Information Document (KIID) and the Supplementary Information Document (SID) as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The Prospectus, KIID and application forms are available in English at octopusinvestments.com. The Authorised Corporate Director (ACD) of these funds is FundRock Partners Ltd which is authorised and regulated by the Financial Conduct Authority no. 469278, Registered Office: 8/9 Lovat Lane, London EC3R 8DW. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London EC1N 2HT. Registered in England and Wales No. 03942880. November 2021. CAM011582

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