Isa ideas: Why smaller UK companies, emerging market equities and dividend payers are showing promise in a time of murky markets

 
Will Railton
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Oil prices and demand for commodities are increasing. But there's reason for long-term optimism (Source: Getty)

A lot can happen in a tax year. For Brits looking to use their Isa allowance to invest in stocks and shares before the window closes on 5 April, the investing landscape has changed remarkably. The only thing that hasn’t is the £15,240 limit you can put into the tax-free wrapper (although it is going up to £20,000 from 6 April).

In the last 12 months, economic growth has returned to many of the world’s leading economies, assuaging fears that the US would tip back into recession or that China would suffer a hard landing. America has elected a tax-cutting, spendthrift President, whose promises of supply-side economic reforms have many convinced that big growth is on the horizon.

The price of oil has risen considerably, spurring inflation and signalling that a rotation into cyclical stocks – and away from bond proxies – is underway. Equity indices across the world have defied gloomy predictions and soared to new heights.

Read more: Crude oil prices are dropping as the US adds to its stockpiles

On closer inspection, however, the outlook doesn’t look so clear. Many argue that even US equities aren’t that expensive, but bond yields remain low – a sign that fixed income investors aren’t convinced that the “Trump trade” has much staying power.

This leaves Isa investors with a dilemma. Most providers will charge you for selling any shares, bonds or funds from your portfolio, and you’ll want to hold investments for a number of years to ride out any market volatility. So you want securities that will do well over the long term – ones that you can buy and hold. So, with the Isa deadline fast approaching, where should you look?

UK small companies

There are a number of reasons to put small cap UK companies in your portfolio this year. The plunge in the value of sterling since Brexit may have put rocket boosters under the FTSE 100, whose constituents make 70 per cent of their revenue abroad, but shares in the UK’s large and mid cap stocks are now looking expensive.

As bond yields have come down, appetite for big defensive stocks has meant that small caps have been trading at a discount for a number of years. Now, fears over Brexit are making the UK small cap class a bargain for contrarian investors.

Of course, there are greater risks to investing in small companies. They are more likely to fail, and their performance may be erratic in the short term. “But,” says Mick Gilligan, head of fund research at Killik & Co, “you’ll be compensated for taking on the additional risk, especially over the long term”.

In fact, the annualised volatility experienced by the FTSE Small Cap index has been more muted than that of the FTSE 100 over the last three years (8.3 and 10.3 per cent respectively), Tilney Group’s Jason Hollands recently pointed out.

If you don’t have the time to research the cash flow of a tiny company (and let’s face it, you probably don’t), actively managed funds are a good bet.

Many such funds will invest in large caps alongside the minnows, providing a useful hedge, as well as offering you better exposure to small companies than a FTSE All-Share tracker fund, for example, whose market cap weighting would mean that you’re buying as much Royal Dutch Shell – the biggest UK-listed firm by market cap – as nearly 300 smaller ones combined.

“Small caps tend to be in diverse sectors, and quite a lot have safer balance sheets compared with mainstream companies, which tend to borrow,” says Gervais Williams, who manages the CF Miton UK Multi Cap Income fund alongside Martin Turner. His fund aims to provide income over the long term through dividends and capital growth by investing in “mundane companies for capital expenditure productivity improvement,” says Williams. “We tend to go for companies which will offer a yield in three to five years”.

The fund topped Sanlam Private Wealth’s most recent equity income study, with a 33.5 per cent income return over the last five years and modest growth. It focuses on Aim stocks but also includes large caps to provide stability.

Gilligan recommends Strategic Equity Capital, an investment trust which invests mainly in UK small cap equities and takes a private equity ownership approach.

Such strategies see fund managers invest in public companies, and influence their strategy and operations to create value without having to buy a 100 per cent stake. The investment trust structure means that the management can invest for the long term, without the threat that shareholders will sell at the first sign of trouble.

Following a change of management in Strategic Equity Capital, the fund has been trading at a large discount to the value of its net assets – 15 per cent at the time of writing. Gilligan thinks this discount has been overdone. “Those taking over have a very similar philosophy,” he says. Henderson Smaller Companies Investment Trust is another fund trading at a significant discount.

Emerging market equities

After a fall at the end of 2016, emerging markets (EMs) are back in favour with investors. Much of this has to do with a higher oil price and demand for commodities as China’s housing market has boomed, but there is cause for optimism over the long term.

Analysis of the “Trump trade” stock market rally by BlueBay Asset Management shows that the rises seen on Japan’s Nikkei and the MSCI Emerging Markets index owe most to a recovery in corporate earnings, rather than the expectations of future earnings growth – the hope that Trump will deliver, in other words – which have pumped up America’s S&P 500.

Read more: Markets in US and Asia wobble as "Trump trade" runs out of steam

Knowing what you’re buying has long been the key to investing in emerging markets, partly because EM stock market indices can be dominated by poor quality firms with large market caps, and an active manager can sort the wheat from the chaff. But broader structural and geopolitical changes mean that actively managed funds could really come into their own.

First, the structure of emerging economies is changing. A shift away from manufacturing and towards services means that the turnover of constituent companies within EM indices is much higher than in developed markets.

This provides active managers who can spot withering industries with an opportunity to outperform the index as a whole. According to UBS strategists Niall MacLeod and Matthew Gilman, there is 120 basis points of “development alpha” to be exploited in the MSCI Emerging Markets index, based on historic performance.

Second, an abundant supply of liquidity from rich world central banks has flowed in and out of emerging markets with little attention given to the countries, sectors or companies being bought. As the US Federal Reserve begins to tighten monetary policy, and President Trump threatens tariffs on countries that export cheaply to America, canny stock-picking may prove key to generating higher returns.

Michelle McGrade, chief investment officer at TD Direct Investing, recommends the cautious, valuation-driven approach of the M&G Global Emerging Markets fund. “It has a strong focus on corporate governance and shareholder value creation. Manager Matthew Vaight has a value bias, looking for out-of-favour companies,” she says. The Hermes Asia ex Japan Equity fund also has a strong value focus.

“The Asian economies are well managed, and structurally sound,” says Bill Maldonado, global chief investment officer of equities at HSBC Global Asset Management. He likes North Asia, which is already reaping the fruits of a cyclical upswing.

Read more: Japanese economy grows one per cent, helped by weaker yen

Economic growth in the US, Europe and Japan has been improving for the last year, and Maldonado expects that Asian economies, which are very exposed to global growth and consumer demand, will benefit in particular. “If there’s going to be a bounce-back in earnings because of an acceleration in GDP, it is going to be in Asia. Valuations are cheap, profitability is bottoming, and that makes us very positive,” he says.

He distinguishes between the “defensive” markets of Indonesia, the Philippines and South East Asia, which have done well in recent years as investors have sought safety from China’s slowdown, and the North Asian markets – Taiwan, South Korea and China – which could be in for a rebound.

More risk-tolerant investors might consider a fund focused on a single country. Central banks in Brazil, Russia, India and South Africa have stuck closely to their mandate to reel in inflation, and may soon cut interest rates. Between Narendra Modi’s reforms, a well-managed central bank, a growing population and an economy supported by domestic demand, India looks well insulated from Trump’s protectionist wrath.

The Stewart Investors Asia Pacific Leaders fund is almost a third invested in India and focuses on large, transparent firms. The Jupiter India fund has been the third best-selling on AJ Bell Youinvest’s platform this Isa season.

More cautious investors might consider the Utilico Emerging Markets fund, which invests in utility companies in China, Brazil and South-East Asia. Its performance has lagged behind the EM rally, and is trading at a wide discount to net-asset value because of issues with subscription shares.

“But the businesses it invests in tend to have a monopoly or quasi-monopoly so have good pricing power in the long term,” says Gilligan. “It pays a yield as well, which is tax-efficient in an Isa, and the subscription shares will have expired within 12 months.”

Dividend payers

Income remains a priority for 86 per cent of investors, the Schroders Investment Trends survey found last year. A reliable source of cash is important not only to those in or close to retirement who may want to draw upon the income, but also to investors looking to reinvest it for growth.

As interest rates and bond yields remain low for now, but a steepening yield curve remains a possibility, the landscape for UK fixed income is relatively bleak. Dividend-paying stocks may be a better option, with yields remaining stable at around 3-4 per cent for a number of years.

Oliver Smith, portfolio manager at IG, recommends the Vanguard FTSE All-World High Dividend Yield, an exchange-traded fund which cuts out stocks which don’t pay a dividend. This ETF is also underweight on pricier areas of the market, such as tech and the US, while offering a 26 per cent allocation to financials, which are expected to perform well if Trump can successfully cut back the thicket of Dodd Frank regulation, and if interest rates around the world begin to rise.

Ultimately, the most important thing for dividend investors is sustainability, an assurance that the cash will keep coming. Listed firms cannot control their share price, but many will dig deep into their pockets to sustain their dividend if it means holding onto shareholders. In other words, just because a stock is paying a dividend now is no indicator that it will keep paying it in the future.

Star manager Neil Woodford stressed this last month at the launch of his own new income fund, Woodford Income Focus. He gave Shell and BP – firm favourites among UK investors – as examples of firms whose dividend payments are being funded through asset sales or debt, rather than cash generation, an indicator that their dividends may be on borrowed time.

Investment trusts provide a good solution to the problem of sustainability. They are funds with a fixed number of shares, giving the manager the freedom to buy and sell without fear of investor flight. And they can keep up to 15 per cent of their income per year as a handy reserve to shield shareholders from short-term losses and ensure a consistent dividend is paid year after year.

“The City of London Investment Trust, Witan, Scottish Mortgage and Temple Bar have all increased their total annual dividend for every year for at least 32 years, providing the ideal combination of both capital growth and income for strong long-term total returns,” said Russ Mould, investment director at AJ Bell. “Investors’ faith in Scottish Mortgage – and the portfolio’s terrific record – are now also being reflected in the trust’s promotion to the FTSE 100.”

However, income investing doesn’t have to be low yield. Some are sceptical of so-called “maximiser” funds, whose managers claim to deliver a yield of 7-8 per cent. But the Schroder Income Maximiser, which pays clients quarterly in cash, managed to deliver a 20 per cent total return last year, and an income return of 43.5 per cent over the last five years. It invests in dividend-paying stocks and writes calls – sells risk – to augment those investments with an income for those trades.

This article appears in the latest edition of City AM's Money Magazine, released with the paper on Thursday 24 March.

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