January 2015 - UK equities
Many moons ago, before most of us were born, equities were correctly perceived as more risky than bonds and, as a result, the yield from dividends was greater than the yield from gilt coupons. Then came the age of inflation through the 70s and gilt yields went well into double figures and the yield gap became the reverse yield gap. With bond yields now seemingly in freefall, the UK 10 year gilt now yields 1.53%*, and the yield gap firmly reinstated, the go to source for income is now the equity market.
For many years the UK equity market was the natural home of income-producing stocks. The banks, oil companies and utilities provided significant dividend pay outs – and, even if you were not looking for an income tilt, the returns from compounding the dividends was compelling. How times have changed. Today the banks have yet to be fully integrated back into the dividend fold – and there remains a question mark over this happening. BP’s Gulf of Mexico debacle took the shine off oil stocks as has the recent decline in the oil price. So it has become much harder for fund managers to provide a consistently reliable source of income. Under the Investment Association guidelines, UK equity income funds must invest at least 80% in UK equities and should achieve a historic yield on the distributable income in excess of 110% of the FTSE All Share yield at the fund's year end. With the FTSE All Share currently yielding 3.37%**that puts the hurdle rate at 3.7%.
Of the 90 odd funds in the sector, 17 don’t make the grade, in terms of producing the yield requirement, but most are close enough to escape the wrath of the Investment Association sector committee or have dividends in hand to get over the line. The doyen of income funds, Neil Woodford, often struggled, in his days at Invesco Perpetual, to produce the required yield, but the current yield on Woodford Equity Income is a solid 4% and the past year has seen him top the charts in terms of fund flows amassing a cool £900 million according to Financial Express.
The sector does provide an interesting spectrum of yields from the 3.7% benchmark it measures itself against, up to and above 8% for the “Enhanced”, “Optimised” and “Boosted” funds that rely on option call writing and other derivative plays to “Maximise” income. As with most things in this world you pay for what you get. If you take the option of enhanced income as a dividend then don’t expect to make as much by way of capital gain. Over the past 12 months with flat to lower markets in the UK a lot of these funds will be showing negative returns after paying out the dividend.
The investor ‘holy grail’ is a fund with a steadily rising stream of income. If in the initial stages the yield is probably less than desired, patience will often be rewarded. Unfortunately, the virtue of patience does not always prevail and a high yield bond fund gets purchased for all the wrong reasons. In rising markets high yield act like a bond and in descending markets it acts like equities, but with asymmetric risk.
So who has been attracting all the money over the past year as the hunt for yield continues? In second place behind Woodford comes another FundCalibre Elite Rated offering, Royal London UK Equity Income, run by Martin Cholwill. His preference is for high yielding stocks generating significant free cash flow to fund sustainable dividend payments. It is monitoring the cash flow that is so important in a sector where it has been known to dry up for unexpected reasons. Currently the watchful eye must be on the oil stocks, which historically have been good payers, but with crude falling from over $100 to below $50, and with no sign of any respite yet, there must be question marks over their ability or willingness to pay. The same is true of the resources sector and over the past three months the stocks most widely sold by equity income managers include RTZ, BP, BHP and Shell.
A fund that has a lot of success by taking high conviction positions and having high active share away from the usual suspects is the Evenlode Income fund run by Hugh Yarrow. The fund aims to produce excess returns with reduced risk. The fund reduces volatility by investing in high quality defensive businesses. They expect the fund to outperform in down markets and underperform in a strongly rising market. The fund is highly concentrated, with its top 10 holdings making up 55% of the fund. These businesses’ revenue streams are extremely well diversified, helping to reduce any stock-specific risk. This has been borne out by recent performance in a tough environment. Since inception, the fund has an average year-on-year dividend growth of 8.8% per annum.
Other funds that make it through the FundCalibre quantitative and qualitative screening process include Standard Life UK Equity Income Unconstrained, Schroder Income, JOHCM UK Equity Income, Threadneedle UK Equity Income and Rathbone Income. As a parting comment it is interesting to note that there are now, and have been for some time, more income-generating stocks in Asia than in the UK; that should be food for thought.
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Clive Hale, Director – April 2015
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