Investing in the equity income sector offers a compelling way for investors to participate in the emerging trends of positive corporate cashflow and improving earnings momentum, says Karen Robertson of Standard Life Investments.
The UK equity income sector has faced significant hurdles over the last few years, with the FTSE 350 High Yield Index struggling to keep pace with its growth-oriented cousins. As has been widely highlighted in the media, 2009 was a particularly arduous year for income seekers.
According to Cazenove, shareholders in UK firms experienced cuts in dividend payments to the tune of £12bn, with companies paying out 18% less to investors than in 2008. The reasons were understandable; in the middle of the recession and with limited access to funding, UK businesses concentrated on preserving their already strained cash reserves.
As a result, over 2009 the FTSE 350 High Yield Index underperformed the FTSE All Share Index by 9.8%. In the main, the dividend cuts were concentrated in the financial sector, as banks, traditionally high-yielding income stalwarts, cut dividends dramatically. Fears over capital adequacy also led many insurance firms to slash payouts, with listed property firms similarly afflicted. Meanwhile, income investors’ returns were further hampered by the fact those stocks that did perform well, such as miners, tended to hail from much lower-yielding sectors.
The appeal of sustainable yield
The recent underperformance of the high-yield index has dented the somewhat safe-but-dull image of income funds. Yet ironically, the case for equity income funds has arguably never been more compelling, as both government bonds and a historically low base rate provide negligible returns for investors. In addition, over the long term, investing in an income strategy where dividends are reinvested has been proven to be more successful than investing in growth funds (see graph below).
When choosing an equity income fund, investors do not have to ignore growth completely. There are funds available, such as the Standard Life Investments UK Equity High Income fund, which can include growth stocks that do not necessarily have an above-average yield.
This ‘barbell’ approach allows such funds to benefit from both a high yield and robust growth from the strongest market performers, thereby offering the best of both worlds.
Ones to watch
Within our UK Equity High Income fund, we retain a large overweight exposure to the mining sector, where we like Xstrata, Rio Tinto and Vedanta Resources. A lower-yielding sector,
these mining stocks provide a solid level of capital growth and continue to offer attractive valuations. We have also been buying Tullow Oil, where we see further significant upside in terms of asset value.
Another sector we have been adding to is utilities, having recently initiated holdings in water groups Pennon and United Utilities. Water stocks are linked to inflation, making them increasingly appealing at a time of uncertainty regarding inflationary pressures. In addition, the stocks should benefit from the return of bid speculation to the sector.
Together with its water business, Pennon is the parent company of waste management
firm Viridor, which is beginning to see upswings in volumes and prices. Meanwhile, peer United Utilities currently yields around 6%. Final proposals from the recent OFWAT review were better than expected and the company now has no need for a rights issue, prompting its inclusion in our portfolio.
Somewhat more controversially, we like various companies within the general retail sector. The wider market is clearly sceptical on prospects for retailers, predicting a tough climate ahead for stores struggling to contend with ever more pressured consumers. While fears over unemployment and tax rises are undeniably valid, consensus forecasts already have such low assumptions priced in that many stores stocks offer solid investment opportunities. For example, home shopping retailer N Brown currently yields 5.2%, while Marks & Spencer offers 4.6%.
The outlook for income
Income funds have been exposed to substantial headwinds over the last few years, but we think the worst of the dividend cuts are behind us and expect market dividend growth to be between 6%-9% in 2010.
In terms of the uncertainty surrounding the broader macro-economic outlook, it is worth remembering the UK is a very open economy. In fact, more than two-thirds of UK listed companies’ earnings are derived from overseas economies, meaning most firms are not tied to the UK in order to grow their top line.
This diversity affords the UK stock market a certain degree of insulation from any domestic economic weakness. Furthermore, UK equities are supported by robust earnings momentum – consensus earnings forecasts have been trending higher since August 2009, which should serve as a positive driver of share prices.
In addition, the financing position of many firms has improved significantly following the £80bn worth of rights issues over the last year, and the upturn in liquidity across the credit markets. Indeed, the majority of blue-chip companies are not having problems raising funds. Balance
sheets are also in sound health, largely thanks to strict cost-control policies.
While the case for UK equities may now seem less clear-cut following the re-rating of various early cyclical sectors, there is still value in large parts of the market, including some of the larger stocks by market capitalisation. In general, UK equities remain attractively valued both on a historical basis and compared to other asset classes after the sharp recovery of 2009.
We are continuing to find many worthwhile opportunities; Aviva, Vodafone, GlaxoSmithKline, British American Tobacco, and BP are all examples of stocks that offer a significant yield premium to the market. The fact so many higher-yielding stocks now offer such value gives us confidence the income sector will see substantial upside in 2010. The recent reinstatement of dividends from firms such as Barclays and Xstrata also stands the sector in good stead.
Finally, we anticipate an extremely low interest rate environment throughout the remainder of 2010, as a fragile economic recovery is likely to lead to lower-than-consensus inflation in the months ahead. Against this backdrop, the hunt for yield will become even more important. In our view, investing in the equity income sector offers a compelling way for investors to participate in the emerging trends of positive corporate cashflow and improving earnings momentum.
Karen Robertson is manager of the UK Equity High Income fund at Standard Life Investments
