The UK Equity Income sector has lolled in the doldrums in recent years compared with the somewhat sparkling returns of the likes of Asia and emerging markets, but things have become more positive in the past 12 months.

The average return from the sector in the year to the end of June was 22.2 per cent, a great improvement on the three-year average return of 20.8 per cent and five-year return of 15.9 per cent. But does that improvement in performance herald a new period of growth for funds in the sector – or is it just the cyclical turnaround of what were comparatively underwhelming investments?

To a degree, the sector is recovering from the pain of losing good dividend income from the banks during the credit crunch as well as the major hit to dividends from BP’s much-publicised problems last year. But Ben Yearsley, investment analyst at adviser Hargreaves Lansdown, believes that the sector offers long-term growth.

‘Because of the yield discipline in the sector, you often find that Equity Income lags other sectors such as small-cap companies in strong market rallies, as it tends to be growth-orientated companies leading the charge,’ Yearsley pointed out. ‘Having said that, over the longer term I would back Equity Income to be a top-performing sector by virtue of the type of companies they invest in.’

Firm foundations
There’s an argument for using Equity Income funds as the bedrock of a widely spread portfolio, but anyone doing so needs to understand what they are. Because of their nature, they are unlikely to offer outstanding returns. However, due to the way that UK Equity Income fund managers work, they can still tap into global growth opportunities.

For instance, when What Investment spoke to Adam Avigdori of BlackRock’s UK Equity Income fund in early July, he was in New York. Why? ‘We try and present something different to clients,’ he explains. The fund managers use what they call a barbell approach to stockpicking.

‘We see the barbell as two pots of money,’ Avigdori says. ‘One has high-quality, high-yielding mature businesses; the other has shares that may not have any yield at all.’

While that sounds counter-intuitive, his reasoning makes sound sense. ‘We spend a lot of time trying to understand how earnings and cash flow in a business can develop,’ he adds. ‘By buying high-growth companies, we hope they will be the high yielders of the future. As they grow they’re going to generate more cash and pay out more dividends. The dream is for companies to move from one end of the barbell to the other.’

Global exposure
This brings us back to New York. The BlackRock fund invests in shares in the FTSE 350 but, in the process, will get exposure to markets across the world.

‘More than 80 per cent of the earnings of Footsie companies comes from global earnings,’ Avigdori notes, mentioning Tullow Oil as one firm that the fund has backed in recent times. ‘So while the UK stock market is a tremendous investment opportunity, many firms get their earnings exposure from outside the UK. It means that we have to spend our time across the world. I’m in New York, for instance, to talk to new people – economists at major banks, political strategists and so on – ahead of the US election in 2012.

‘Understanding the global economy and the things that will impact on it is an essential part of our job, as events such as a major election or a catastrophic tsunami will impact on the UK stocks that we invest in.’
The BlackRock fund has been outstripped by some of its rivals in the sector in the past 12 months but is 16th over five years and 11th over three years. Consistently number one over all three time periods is the Unicorn UK Income fund, which grew 39.6 per cent in the past 12 months, 82.4 per cent over three years and 62.1 per cent over five years.

Senior manager John McClure tends to back manufacturers of high-value specialist products that have benefited from the surge in demand from countries such as India and China. In other words, the fund has provided consistent outperformance based on growth in emerging markets.

Paying dividends
Dividend income growth is a common theme when you talk to UK Equity Income fund managers. Rather than simply pick the stocks that have historically provided the highest dividends, many look to companies that may offer higher dividends in the future.
Michael Clark, manager of the Fidelity Income Plus fund, is banking on such stocks to improve his fund’s somewhat sluggish recent performance – 70th in the sector over 12 months, but 26th over three years.
‘I do like the idea of dividend growth,’ he says. ‘Dividends can be the most important part of long-term returns from stocks. The most important point about dividends is that we are not in the same sort of environment as we were in 2008. There may be some worries about the economy, but there won’t be a tidal wave of dividend cuts as there were then.’

He is positive about future prospects for the sector. ‘In terms of sources of income, the dividend streams are growing. If you look at our main holdings, such as Glaxo, Vodafone and BT, in all of these areas I expect to see a dividend increase. Most have international arms, and the presence of growth in the Far East is helping their growth.’
Despite the recent bad experience with banks, when dividends were slashed, he does expect them in due course to return to Equity Income portfolios. ‘I don’t see Lloyds returning to a meaningful dividend for a few years, but banks will come back to be the bedrock of dividend flows, albeit some years ahead,’ says Clark.

Enduring appeal
The enduring attraction of the Equity Income sector is perhaps best signified by the fact that new funds are still being launched – two in the past few months alone. Former Gartmore stalwart Gervais Williams has just launched a new UK Equity Income fund for MAM, for instance.
‘It’s going to be tough to get good income growth in the next few years,’ he admits. ‘We need to identify companies that are going to grow as a lot of larger companies could be constrained.’

He believes that there’s much greater scope for stockpicking at the bottom end of the market at the moment, and his
fund has a simple philosophy of finding a group of companies that are well placed to grow their income faster than some of the bigger companies.

‘For instance, CML Electronics is a British firm that is currently seeing some good demand and a strong balance sheet, and for the first time in a few years has resumed its dividend,’ says Williams. ‘There are other examples, and I believe that there are some great opportunities to get into income stocks looking ahead.

‘Many of the ones that we’re interested in may be formerly listed firms, with a sustainable business, a strong asset base and good potential. There’s also the chance that they may become takeover targets, which increases the growth opportunities.’

Richard Black, fund manager of the Legal & General UK Equity Income fund, launched at the end of March this year, is very bullish about prospects for the sector. ‘The next few years for Equity Income is going to be a vintage period,’ he says. ‘For many companies it’s all going to be about yield, making Equity Income an increasingly attractive sector.’
He cites Vodafone as an example of a stock included in many Equity Income funds: ‘It’s got a strong market position and consistent dividend growth, and offers more of the same as data demand growth will drive revenue growth and profit growth.’

Chemical attraction
But it’s not just about the big blue-chip firms, according to Black. ‘Croda is a speciality chemicals business that is set
for outstanding growth in the future,’ he observes. ‘It produces the active ingredient for a lubricant used in beauty care products, such as face creams, and will benefit from increasing demand for beauty products from Asia, where skin-lightening products, for instance, are in huge demand.’

However, as you would expect with income seekers, Black says that he doesn’t take unnecessary risks with his stock selection. ‘We back our best ideas across sectors, with just 30 to 40 stocks in the fund – we want every stock to count,’ he says.

Is there a wrong time to buy Equity Income? Ben Yearsley says that depends on what kind of investor you are. ‘As long as you are a long-term investor, the answer is no, but clearly timing does play more of a part over the shorter term,’ he warned.

‘I think the outlook is very good at the moment for Equity Income. The economic recovery is going to be a bit of a grind, so companies with predictable and defensive earnings streams could be the ideal place to be invested.’ He picks pharmaceuticals and tobacco firms as good examples.

Which funds to choose?
‘Funds such as the Invesco Perpetual Income fund or maybe Bill Mott’s Psigma Income are possibilities,’ says Yearsley.

Darius McDermott, managing director of Chelsea Financial Services, mentions Invesco’s High Income fund, along with Artemis Income. ‘There are a number of cash-generative stocks with strong balance sheets that are producing an attractive yield,’ he explains.

‘With this in mind, the question is: why would a medium-risk investor lend money to the government at 3.2 per cent when they can get shares in Glaxo at 5.1 per cent with the potential for capital growth?

‘The best UK Equity Income funds that are targeting these types of companies are Invesco Perpetual High Income and Artemis Income. These funds have positioned themselves defensively with the expectation that the market has yet to see the recovery potential in some of these stocks.’

Adrian Lowcock, senior investment adviser at BestInvest, also highlights Artemis. ‘Adrian Frost, manager of Artemis Income, has delivered solid performance over his 22-year career, with the fund currently yielding 4.1 per cent.’ He also picks Threadneedle UK Equity income as a strong performer.

‘The power of dividends being reinvested should not be ignored, and as such remaining in Equity Income funds even through the lean years is essential to the long-term performance of this asset type,’ Lowcock says.
‘While many comment on short-term performance, for most of us finding a reliable long-term investment strategy that works is the ideal situation. Equity income does this.’

Publication:
What Investment

First published:
1 August 2011

Journalist:
Simon Read

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