Five plays for contrarian investors

published 28 February 2007

A fund in the UK Equity Income sector should generate a yield of at least 110% of the FTSE All-Share index, according to Investment Management Association guidelines. Of course, the higher the yield you have to seek, the more restricted you are when it comes to investing. The F&C UK Equity Income fund, which has a yield of 3.2% against the FTSE All-Share average of 2.8%, is therefore limited in its options when it comes to investing in outright growth stocks. Our search for higher-yielding stocks encourages a contrarian approach, which pushes high-income-generating funds towards sectors out of favour with the market.

Top sectors for contrarians: oil and pharmas

As such, we are overweight in oil and pharmaceuticals. As well as looking cheap relative to the UK market, oil giants BP (BP.) and Shell (RDSA) trade on large discounts to their global peers. After a string of problems such as the Texas oil refinery blast, spills from its Alaskan pipelines and uncertainty over the leadership of CEO Lord Browne sentiment towards BP is very poor. Its p/e ratio has fallen to less than ten times, but it is also generating an attractive dividend yield of 3.7%, which it is raising by 10%, and it has bought back 6.5% of its shares in the last year. Shell, too, has been beset by troubles in the past such as its contractual woes on the Sakhalin project in Russia and its oil reserves accounting which have left it trading on a similar p/e and dividend yield to BP. Hopefully, with the bad news behind them, the next 12-18 months will mark a period of better returns and improved ratings as investors start to look at both stocks more favourably.

The pharmaceutical sector also looks attractive. Bad news has hit GlaxoSmithKline (GSK) and AstraZeneca (AZN). Both have seen upsets with key drugs in development, resulting in delays or the need for a complete rethink. However, in the long-term process of drug development, upsets are inevitable and, after this phase of disappointing developments and falling returns, we believe the firms could be close to a turning point.

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Perhaps for the first time the industry has to reappraise its financial structure and cut its cost base. Balance sheets have been underutilised in the past; the result of the reappraisal is expected to be an increase in capital returned to shareholders, either through share buybacks or by raising dividends ahead of market rates. These developments are at an early stage, but there are similarities to the turnaround made by Vodafone. Once a top-performing growth stock, since 2005 Vodafone has been hiking its dividends aggressively. While we aren't expecting such a dramatic transformation, any significant change to the pharmaceutical industry's approach would be well received.

We are also watching supermarket giant Sainsbury's (SBRY). The dividend was cut after a period of poor trading but, although the shares looked expensive relative to earnings, this overlooked the greater value held by the supermarket, which owns most of its own stores. Private equity has been very active in the UK market recently, and it has created value by buying companies and then separating the property assets from the operating companies. This could happen to Sainsbury's too. A consortium including CVC, KKR and Blackstone is assessing an offer for the group. Whether the offer is forthcoming or not, it highlights that there is more value in the company than trading would suggest.