Four attractive UK income opportunities

Each week, a professional investor tells us where he’d put his money. This week: Mark Barnett, Perpetual Income and Growth Investment Trust.

The UK equity market offers one of the most attractive levels of income of all global equity markets. However, this income has traditionally been generated by a concentrated mix of large-cap stocks. I seek to create a diversified portfolio of income-generating companies with the potential to grow those payments ahead of inflation over time. The ability of investments to generate sustainable free cash flow and the attitude of company management towards shareholder distributions is crucial to success. Fortunately, within the UK market, there are some very interesting areas of opportunity.

Domestic firms hit by Brexit

Negative sentiment towards sterling and domestic companies since the EU referendum has resulted in a wide degree of polarisation within the market. Companies with substantial overseas revenues have benefited from the devaluation of sterling, but domestic-facing stocks have been derated indiscriminately. This has created an opportunity to purchase shares in businesses with strong fundamentals at attractive prices.

One area that offers evident value is real estate, where political uncertainty has placed significant pressure on valuations. Within this sector, NewRiver Reit (LSE: NRR) stands out. This real estate investment trust offers highly diversified income from retailers that are growing (discounters and convenience stores) and are relatively resilient to online challenge. Roughly one fifth of the portfolio is pubs, while the top-ten retailers account for less than 15% of NewRiver’s rental income and there is virtually no exposure to department stores.

Retailer Next (LSE: NXT) is another business operating within a Brexit-hit sector, while shares face the additional challenge of the pessimistic story around high-street retailers. However, the company is challenging this narrative. Next released encouraging full-year results in May that included a 15% rise in online sales – evidence that the company’s multi-channel offering allows it to see the growth of online shopping as an opportunity not a threat. Meanwhile, the increase in the annual dividend reaffirmed Next’s focus on shareholder returns.

Fears about tobacco are overdone

At the other end of the market, tobacco is also facing challenges. The resurgent threat of regulation and concerns around industry disruption have perturbed investors and seen valuations tumble across the sector. To my mind, this pessimism is overdone. A viable next-generation offering has become a principal part of the long-term strategy for the tobacco industry. Companies such as Imperial Brands (LSE: IMB) and British American Tobacco (LSE: BATS) are at the forefront of developing new technologies, with the resources to drive successful innovation. Furthermore, the impact of proposed legislation is unknown and will, if successful, take years to implement. If companies continue to focus on product innovation, while maintaining profit margins on traditional tobacco, they should also continue to provide a reliable source of income. The historic commitment of company management to return cash to shareholders makes tobacco stocks a very interesting area of the market, especially as they have fallen so dramatically over the past two years.