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Investec's 3 UK Income Stock Picks

Emma Wall

Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Blake Hutchins to give his three stock picks. Blake runs the Investec UK Equity Income Fund.

Hi, Blake.

Blake Hutchins: Hi, Emma.

Wall: So, what's the first stock you'd like to highlight today?

Hutchins: So, the first one I'd highlight is a core holding in the Investec UK Equity Income Fund. I've owned it for seven years; I've known it for over 10. It's Sage, the UK software company that provides accountancy software to small and medium-sized businesses. Now, I wouldn't usually pick a company that's so, in my mind, reasonably uncontroversial. But actually, the share prices have come off quite strongly recently. Its shares are down 20% from the peak and I don't think much has changed within that business. What we love about that business is its consistent cash generation. It's a growing business, growing its top-line 6%, 7%, 8%. It's growing its free cash flow a similar amount because it converts all of those profits into cash. It's reinvesting for future growth and it's paying our clients a nice growing dividend. So, that would be my first pick. Back to an interesting valuation and it's got many years of compounding growth ahead of it.

Wall: I suppose the important question then is, although these things aren't always logically explained, why is it come off 20%? Why is that not a warning for you?

Hutchins: Yeah, that's a fair question. I think it's a lot to do with rotation within markets. Some of these slower-growing or more predictable businesses are viewed to be a bit more bond-like. And given the fluctuations in interest rates and adjustments for inflation rates, I think, some of these longer-duration assets have been sold off. Now, I don't know whether the time is exactly now, but what I do know is that at a 5.5% free cash flow yield, north of 2.5% dividend yield, growing both its cash flow and its dividends nearly double-digits, for me, that sounds like an interesting opportunity.

Wall: What's the second stock today?

Hutchins: The second one is a little bit more controversial. That's the Daily Mail and General Trust. Now, let me just be clear upfront. They do own the Daily Mail newspaper, but that's only 25%, 30% of their business actually. And it's really for the remainder of the business that I really like the shares. About 70% of their profits, and growing every year, comes from very high-quality subscription media assets. They own businesses that serve the insurance industry, the education industry, the property industry. And those are all growing areas for DMGT. Again, it's a very cash-generative business. A pound of profits tends equal a pound of cash. They pay out about half of their free cash flow as a growing dividend. And with a 4% dividend yield upfront we think that that's a good valuation today.

Wall: It's not an industry that is without its troubles though. There are headwinds for media. Why do think this one is going to be the one that lasts?

Hutchins: Yeah, I think, if you look at the business outside of the newspapers, they are very well invested. They spend a lot of money, both through the P&L and through the cash flow statement in terms of reinvesting for future growth. And also, the family interest in that business gives it a very long-term mindset. And you see it time and again that these companies that are run with a longer-term mindset and more with a family type of ownership mentality, tend to survive the test of time and get through these more challenging periods. So, those are a couple of the reasons why.

Wall: What about the third and final pick?

Hutchins: So, the third one is an industrial business actually called Essentra. Essentra has had its difficulties in the last few years. They had a previous Chief Executive who probably overstretched the business in terms of M&A. And then in the last year you've had the business return to a much surer footing. In fact, they had full year results just last week. And we were quite encouraged by their recent results. The new Chief Executive is called Paul Forman. He has been there for a year. He is very experienced at turning around industrial companies.

And really, this is actually quite a boring business and boring in a good way, as in, it shouldn't be blowing itself up, it shouldn't be shooting the lights out. They basically have three businesses; a packaging business, a business that provides filters into the cigarettes industry primarily, and then they also have a distribution business which is very, very high quality. Now, all of these businesses have an ability to grow. They make good margins from them. It's quite a cash-generative business. And when I look at the valuation today, I think we are looking at trough profitability for this business. And I think that profits could easily be 50% higher in the next three years or so. And from a starting base of about 14 times EBIT, I'm quite interested in that company right now.

Wall: Blake, thank you very much.

Hutchins: Thanks, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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