After last year’s relatively poor showing, 2010 should prove to be a more rewarding time for equity income investors
The UK equity income sector did not cover itself in glory in 2009. With the average return for funds in the combined IMA UK Equity Income and UK Equity Income & Growth Sectors trailing the FTSE All-Share Index by over 6%, albeit up markedly in absolute terms, many UK income fund managers will probably want to consign last year to distant memory.
Downward pressure on dividends amid some of the toughest trading conditions for decades was an inevitable drag upon the sector, but many funds were hurt by their heavily defensive positioning when the stock market, led by cyclical stocks, snapped back sharply from March onwards. Successful income investing in 2009 required a pragmatic rather than dogmatic approach and a measured stance on sector risk it seems. We think this will continue to be the case in 2010.
The structural advantage of being small
Last year’s performance headwinds were arguably short term in nature, but we think there are structural traits inherent in the UK equity income fund universe that are arguably disadvantageous as far as retail investors are concerned.
One notable feature of the sector is its domination by a handful of high-profile, multi-billion pound funds. Clearly one should respect these fund managers for their success in raising assets and, in some cases, strong long-term performance, but do these huge funds best serve the interests of retail investors? In our opinion, smaller funds have an innate advantage over their larger counterparts.
Their size gives them the flexibility to find investment opportunities across the full market-cap spectrum, allowing them to delve into the less explored recesses of the market to pick up compelling high-yielding opportunities. In contrast, investing in small and mid-cap stocks can be a real challenge for unwieldy multi-billion pound funds, generally limiting their universe to larger companies thus inhibiting their ability to generate outperformance for their fund holders. We have taken the decision to cap the capacity of our own fund at £750m in order to preserve our investment flexibility. We think this has and will continue to provide our investors with a structural advantage.
In the market recovery of 2009 there were many smaller company stock ideas that could have been profitably harvested. There are still attractive propositions in today’s market for equity income managers with the latitude to invest in smaller stocks.
Majestic Wine is one example of a small-cap stock we hold that might be inaccessible to some of the largest UK income funds. We like it for a number of reasons: it is benefiting from supply-side change after the departure of rival Threshers from the high street; its change in policy from a minimum 12-bottle purchase to a minimum six-bottle purchase has led to a jump in customer visits; and the company intends to roll out more stores in 2010 and beyond. These factors should all prove positive for its earnings profile.
In the mid-cap arena, betting company Ladbrokes is another stock that catches our eye. It has a terrific brand and dominant market position, but has suffered from poor operational management. With a powerful new non-executive board in place the company’s potential for improved earnings and strong free cashflow generation will begin to be fulfilled.
So, being smaller has its advantages. It means we can own Majestic Wine, Ladbrokes and others outside the FTSE 100, considerably widening the pool of investment opportunities.
Yield transparency
Aside from dominant multi-billion pound funds, another potentially contentious feature of the UK equity income fund landscape is the practice of using derivatives to enhance dividend income, through a process known as covered call writing. This approach works best for the option writer in periods of modest market volatility when stocks remain flat or achieve modest gains, allowing the seller to pocket the premium while keeping the capital gain. The premium income from this process serves to boost the yield of a fund, and a number of UK equity income managers have been using this method to bolster their payouts.
Using derivatives to enhance a fund’s dividend is perfectly acceptable. Our issue with it is transparency: who is doing what and how much of a fund’s dividend is driven by this approach? Covered call writing is not as secure as normal dividend flow as a fund manager may decide market conditions are not right to write covered calls. Furthermore, the price of volatility may fall, as it has done over the last 12 months, making it less profitable to follow such a strategy.
Relying on a clean dividend represents a clearer, more straightforward and consistent approach and we do not use derivatives to generate additional yield. Instead, we depend upon a strict yield discipline: every stock held in the fund must yield more than the FTSE All-Share Index on a prospective basis while retaining the scope for capital appreciation.
Reasons to be cheerful
Setting questions of fund size and income transparency aside, what are the prospects for the income sector in 2010? Our sense is the broad market remains sceptical about the foundations of the market recovery and the outlook for stocks in 2010. Based on that outlook, many income managers still heavily favour defensive stocks, such as tobacco and food and beverage companies, which they argue have been left behind in the cyclical rally and appear undervalued.
Superficially this may be the case when one considers the low earnings multiples on which the likes of Imperial Tobacco, Diageo and National Grid currently trade. But the highly geared nature of these companies means, on a debt-adjusted basis, these stocks are more expensive than they appear. Instead, we favour lowly geared or companies with net cash and believe it is important to be highly selective in terms of any defensive exposure given high balance sheet-adjusted valuations.
We see reasons for measured optimism this year. Headwinds obviously exist in the form of pressure on public finances and the need for further deleveraging by banks and consumers. Nevertheless, economic activity is recovering, while improving unemployment trends, the delayed impact of the stimulus package and emerging markets growth should make a ‘double-dip’ recession unlikely in our opinion.
Indeed, we may well be surprised by the strength of corporate earnings over the next 12 months, which could see earnings growth of between 20% and 30% and a resumption of dividend growth across the market.
We have been encouraged by the large number of positive trading updates issued by companies held within our fund. The fact the consensus earnings on a number of our stocks do not reflect their current trading performance, coupled with the low valuations of many of these stocks, instils us with confidence.
Looking at the asset class in the round, income stocks look a far more attractive proposition than corporate bonds, which appear priced for perfection and which, in many instances, are currently offering inferior yields. After last year’s relatively poor showing, 2010 should prove to be a more rewarding time for equity income investors.
James Lowen, senior fund manager, JOHCM UK Equity Income fund
