Equities The new best friend for income hunters?
Brian Gallagher Portfolio Manager of the UBS UK Equity Income Fund
March 2009
This document is for Professional Clients only. It is not to be distributed to or relied upon by Retail Clients under any circumstances.
2
Agenda
Life is tough – all exits appear to be blocked
Market outlook
How can UK equities provide income?
3
Life is tough
The Economist6 – 12 December 2008
Financial Times31 December 2008
FT Weekend3 – 4 January 2009
4
All exits blocked – deposit rates
UK clearing banks base rate – middle rate
0
2
4
6
8
10
12
14
16
18
1950 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
Source: DataStream from 31 January 1950 to 30 January 2009
Jan 1950 – Jan 2009
All time low
5
All exits blocked – gilts May 1986 – Jan 2009
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
May-86 Nov-88 May-91 Nov-93 May-96 Nov-98 May-01 Nov-03 May-06 Nov-08
UK 10 year gilt yield - FTSE 100 dividend yield (%)
US 10 year treasury yield - S&P 500 dividend yield (%)
Source: DataStream from 15 May 1986 to 9 January 2009
6
0
2
4
6
8
10
12
14
16
18
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Year
Def
ault
Rat
e (%
)
Actual Default Rate Matterhorn Ayers Rock
All exits blocked – corporate bonds
The implication of an expected peak default rate of 12 – 17% over the course of the next 18 months under the “Matterhorn” default scenario implies almost a default a day
Source: Bank of America Securities–Merrill Lynch
7
50
60
70
80
90
100
110
120
130
140
150
1983 1988 1993 1998 2003 2008
(%)
Top 10 historic dividend yield
All exits blocked - high yield equity strategy not working
Source: MF Global Securities as at 31 December 2008
Cumulative average annual relative return
8
All exits blocked - strike 4 for dividend income
Source: UBS Global Asset Management. YTD is to 31 January 2009.
£674m
£923m
£1.5bn£1.5bn
£1.7bn
2004 2005 2006 2007 2008 YTD
Cut in
div
iden
ds (£
)
£10.5bn
Abbey NationalSafeway
RMC GroupCountrywide
Assured Group TBI
PLC
O2Exel
Peninsular and Oriental Steam
NavigationPilkington
RACSomerfield
Geest
BAABOC Group
Gallaher Group
Alliance Boots
Brambles IndustriesAlliance UniChem
Corus GroupViridian GroupAWG
Wilson BowdenStanley leisure
De Vere Group
John Laing
Scottish Power
HansonNorthern Rock
Imperial Chemical Industries
Kelda GroupEMI GroupEmap Int
GCAP MediaAlfred
McAlpineAbbot Group
HBOSLloyds TSB
A&LB&B
WoolworthsEnodis
JJBRentokil
Topps TilesAGA RBS
WolseleyKingfisher
ITVF&C
PersimmonDSGIPunch
Trinity Mirror
Dividend cuts
AngloAmerican
Wetherspoon
Cookson
Travis Perkins
British Airways
Xstrata
Market outlook
10
Note: Past performance is no guarantee of future resultsSource: Stifel Nicholas. For 1826 through 1925: Combined individual stock prices for NYSE stocks. Goetzmann, William N., Ibbotson, Roger G. and Peng , Liang, A New
Historical Database for the NYSE 1815 To 1925: Performance and Predictability (July 14, 2000). Yale ICF Working Paper No. 00-13; Yale SOM Working Paper No. ICF - 00-13. Available at SSRN: http://ssrn.com/abstract=236982. For 1926 to 1958, Ibbotson Large Capitalization US stock market total return and in subsequently, the S&P 500 total return.
1 Returns based on calendar years; calendar year 2008 data updated through 31 December 2008.
2008: The worst 10-year return period since 1938
-5
0
5
10
15
20
25
1835 1860 1885 1910 1935 1960 1985
Annualised rolling 10-year nominal returns
(%)
Y/Y %, 10-yr annualised Average
2008
10-year moving annualised nominal returns1835-20081
11
0
5
10
15
20
25
30
1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
UK
Tra
ilin
g P
/E (
%)
Equities are cheap…
Source: DataStream to 31 December 2008
…but not quite at historical lows yet
1212
Rich pickings for forward looking investorsSubsequent returns from recessionary troughs
Source: National Bureau of Economic Research (NBER), UBS Global Asset Management Returns based on S&P 500.
38%
58%
31%
-18%
60%
68%61%
38%44%
37%
-7%
14%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
1970 – 1971 1974 – 1975 1980 1981 – 1982 1990 – 1991 2001
Trough +12 months Trough + 24 months
13
Reasons for cautious optimismQuantitative easing has begun already, not after a decade
Growth in estimates of the monetary base, 3 months on 3-months one year earlier (%), years from peak
(10)
0
10
20
30
40
50
60
70
80
-3 -2 -1 +0 +1 +2 +3 +4 +5 +6 +7 +8 +9 +1
Years
Gro
wth
Japan (Aug 1990)US (Sep 2007)UK (Sep 2007)Eurozone (Sep 2007)
Note: UK data has a structural break in 2006-2007, so year-on-year data is excluded for those years.Source: IMF, Bank of England, Federal Reserve
14
Sometimes the darkest moment represents the greatest opportunityTwo year returns; starting from lowest level
Source: Datastream; Currency MSCI: local, Currency JPM EMBI+: USD. These figures refer to the past. Past performance is not a reliable indicator of future results
70
80
90
100
110
120
130
140
150
Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00
JPM EMBI+Asia (Total return)
1997 – 1998: Asian Financial Crisis
+59%
1998: Russian Financial Crisis
0
20
40
60
80
100
120
140
Apr-98 Oct-98 Apr-99 Oct-99 Apr-00
JPM EMBI+Russia (Total return)
+283%
50
60
70
80
90
100
110
Apr-00 Apr-01 Apr-02 Apr-03 Apr-04
MSCI World (RI)2000 – 2003: Dot-com bubble / US recession
+43%
1987: Crash
70
80
90
100
110
120
130
Oct-87 Apr-88 Oct-88 Apr-89 Oct-89
MSCI World (RI)
+55%
How can UK equities provide income?
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The 6 D’s
1. Diversify
2. Dollar
3. Dependable
4. Dominant
5. Derivatives
6. Developments
Key themes equity income investing for 2009
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0%
5%
10%
15%
20%
25%
30%
35%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
UK stocks 2005 Continental European stocks 2007
1. Diversify
Source: Dresdner Kleinwort
Ex-dividend schedule, % of total income
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2. Dollar
GlaxoSmithKline
Royal Dutch Shell
BP
HSBC
AstraZeneca
Rio Tinto
BHP Billiton
Anglo American
SABMiller
Standard Chartered
Xstrata
ShireSource: Bloomberg1 Source for statement: Morgan Stanley Research
US dollars accounted for over 40% of market profits in 20071
19
90
95
100
105
110
115
120
125
Jan-08 Apr-08 Jul-08 Oct-08
Rela
tive p
erf
orm
an
ce
3. Dependable income
A basket based on our 12 ‘gold-plated’ dividend ideas would have outperformed by 20% this year
Source: DataStream, Morgan Stanley Research
AvivaBP
BATGlaxoSmithKline
Home Retail Group Land Securities Group
Marks & SpencerNational Grid
PearsonRoyal Dutch Shell B
Scottish & Southern EnergyVodafone
+20%
Secure yield not high yield
Admiral
20
0
2
4
6
8
10
12
14
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
(%)
UK Gilt Yields BP/HSBC/VOD/GSK DY Blend
4. Dominant
Source: Citigroup as at 31 December 2008
21
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07
5. Derivatives
Source: DataStream and UBS Global Asset Management
BS S
SS
S
B
B
B
B
Vodafone – covered calls enhance income and keep capital upside
22
6. Developments
Market
closedEquities
Debt
ConvertibleHigh Coupon paper with rights to
convert into equity at pre-agreed price at later date
Funding gap
Market
closed
Convertibles
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A balanced approach
Yield
P/E
Barbell High Yield Barbell
Total
Return
Balanced Approach
Covered Calls
Remains appropriate
Randgold
Capita Astra ZenecaGlaxo
Scot & Southern
Nat Grid
BP
BGShell
BAE Systems
DeLaRueDominos Pizza
VodafoneCentrica Admiral
RSA
Aberdeen
BATS
Imp Tobacco
Morrison
Tesco
Pearson
Autonomy
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Source: UBS Global Asset Management as at December 20081 Historic yield, based on ‘A’ income shares priced as at 31 December 2008. Represents yield generated from the portfolio, European stocks, income
opportunities and covered calls.
UBS UK Equity Income – core principles remain the same
Equity income 20 7.00 1.34
Typical % of Fund Yield (%) Yield calc
Megacaps 50 6.00 2.85 Mid/Small caps 10 4.00 0.35 Growth 10 4.00 0.35 Tactical 0 – 5 0.00 0.00 European 10 7.00 0.70
TOTAL 100 5.59
Covered calls 0 – 20
Overall yield 7.30 1
25
Conclusion
All investors face a challenging period
Secure income is especially difficult to find
Tactical use of covered calls works in rising and falling markets
Balanced, multi-dimensional approach necessary
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UBS UK Equity Income Fund
Aims to provide a yield of 120% of the FTSE All-Share Index
Aims to deliver year-on-year dividend growth
A current yield of 7.3%*
S&P ‘AA’ Rating
Quarterly income distributions
Note: As the annual management fee of the Fund is charged to capital, the potential capital growth of the Fund will be reduced. Neither the index or sector out performance nor the yield target quoted are part of the Fund’s investment objective and are indicative only.
1 Historic yield based on ‘A’ income shares priced at 31/12/08
Appendix
28
This is not the Great DepressionCatastrophic fiscal and monetary policy errors prolonged and deepened the economic contraction of the 1930’s
Poor fiscal policies during the 1930’s stemming from balanced-budget political agendas hurt economic growth
Real interest rates exceeding 12% as a result of massive deflation during the 1930’s severely dampened investment
Unprecedented fiscal and monetary policy responses we believe stimulate growth going forwardSource: FDIC, Federal Reserve Bank of St. Louis, Consensus Economics, UBS Global Asset Management1 2009 forecast released by the Congressional Budget Office2 Consensus mean for 2009 annual contraction in US GDP provided by Consensus Economics3 Consensus mean for 2009 Consumer Price Index provided by Consensus Economics4 Money supply measured by the M2 money supply which includes currency in circulation, demand deposits, travellers cheques, savings deposits, time
deposits, and money market accounts
Indicator Current recession 1929 – 1933
Real GDP Contraction -1.3%2 -29.0%
Unemployment Rate 7.2% 25.0%
Consumer Prices 1.2%3 -25.0%
Money Supply4 7.2% -33.0%
Budget Deficit (% of GDP) 10.1%1 2.6%
Bank Failures 25 7,000+
29
Number of consecutive years
2 3 4 5 10 18
Probability of Equity outperformance of Cash
67% 70% 74% 74% 92% 99%
Probability of Equity outperformance of Gilts
69% 76% 77% 75% 81% 90%
Has the market already priced in the bad news for equities?
Source: Barclays Capital, Equity Gilt Study 2009. Data as at 31 December 2008
Equity performance probability
30
3
4
5
6
7
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
%
600
800
1000
1200
1400
1600
1800
US: Cash as % of stock mutual funds MSCI Europe (rhs, inv)
Waiting to be reinvested when visibility gets better
US mutual fund liquid assets as a % of US assets under management
Cash on the sidelines on the rise
Source: ICI, UBS, DataStream to December 2008
31
£10
£100
£1,000
£10,000
£100,000
45 53 61 69 77 85 93 01
UK Financial History – dividends grow not bond coupons
Note: Scales calculated on a logarithmic basisSource: Barclays Capital, DataStream, Scottish Widows
07
£131,639
£8,511£4,550£2,876£1,833
£49
Barclays Equity Index Dividends Reinvested
Barclays Equity Price Index Ex-Dividends
Barclays Gilt Index Income Reinvested
Retail Prices Index
UK Building Society Index Income Reinvested
Barclays Gilt Price Index Ex-Income
32
Derivatives – covered calls
A covered call is a transaction in which the seller of call options already owns the corresponding amount of the underlying shares but agrees to sell them at a pre agreed price at a date in the future
These owned shares provide the ‘cover’ as they can be handed over to the buyer of the options when he/she decides to exercise them
In return for agreeing to sell them the seller will generate income, in the form of the premium paid by the option buyer
UBS UK Equity Income Fund employs a disciplined approach to covered calls
4 golden rules
1. Only use traded options
2. Only sell calls when share price has performed strongly
3. Only 10% of fund exposed to calls in total - 2% per position
4. 10% stop loss on positions not working
Low risk income generation
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Important informationThis document is for Professional Clients only. It is not to be distributed to or relied upon by Retail Clients under any circumstances.
Past performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and are not guaranteed. Investors may not get back the amount originally invested. Neither the sector performance nor the yield target quoted are part of the Fund’s investment objective and are indicative only. As the annual management fee of the Fund is charged to capital, the potential capital growth of the Fund will be reduced. The data contained in this document has been sourced by UBS and should be independently verified before further publication or use. The relative performance data is based on arithmetic methodology.
This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the FSA requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document should not be considered a recommendation to purchase or sell any particular security and the opinions expressed are those of UBS Global Asset Management and are subject to change without notice. Furthermore, there can be no assurance that any trends described in this document will continue or that forecasts will occur because economic and market conditions change frequently. Telephone calls may be recorded.
© UBS 2009. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. Issued in March 2009 by UBS Global Asset Management (UK) Ltd, a subsidiary of UBS AG, 21 Lombard Street, London EC3V 9AH. Authorised and regulated by the Financial Services Authority.
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