Karen Robertson, fund manager at Standard Life Investments, discusses the environment for high yield stocks going into 2006 and why a combination of value and growth is needed to achieve optimum returns
The UK corporate sector looks healthy going into 2006. Companies are trading at their highest free cashflow yield for 10 years. This is feeding through to greater dividend growth, more share buybacks and is one of the reasons for the recent increase in bid activity. This high level of dividend growth will be supportive for income funds during 2006.
Companies are increasing their payouts to shareholders, and hence we expect dividends to grow by high single-digit numbers over the next few years. Certainly, as we move into 2006, we expect corporate earnings growth to moderate as the latest cost pressures from energy and other raw materials begin to make themselves felt and output pricing, particularly in manufactured goods, remains subdued. The global economy has had to adjust to an historically high oil price, which we saw reach $70 per barrel last autumn. The counterpart to this are the strong prospects for UK firms, reflecting both the fact that over 20% of the UK stock market comprises mining, oil and gas firms, as well as the favourable export prospects, for example in terms of demand from fast growing Opec economies.
We expect the increase in bid activity to continue into 2006. Indeed, in the fourth quarter of 2005 we saw a resurgence in merger and acquisition activity with the small- and mid-cap sectors boosted by the potential bid for P&O Ports, Persimmon's takeover of Westbury, and Talisman Energy's acquisition of Paladin Resources. Overshadowing these somewhat was major bid activity in the large-cap arena including Saint-Gobain's hostile bid for BPB, a nearly £18bn offer for 02 by Telefonica, and Deutsche Post's acquisition of Exel. The valuation of UK companies and healthy corporate cashflows are enticing more overseas investors into UK equities. Corporate profitability across Europe is high, and so engaging in merger and acquisition activity further afield is another to way to utilise cash. More importantly, European companies are finding opportunity and value in British companies that they cannot find in their own backyards.
The current economic and market environment should allow companies to continue to pay generous dividends. We expect to see dividend growth of around 10% during 2006. Those companies that report in dollars, but pay dividends in sterling, will also be supported by the strength of the dollar. A combination of attractive valuations, strong earnings and dividend growth, and an increase in bid activity, lead us to believe that the market has entered 2006 in healthy shape.
Exploiting growth and income
While the market environment in 2006 is likely to support income investors, we believe there will be less of a difference between the income and growth approaches to investment going forward. This view is based on valuations. A few years ago, companies like Vodafone and BSkyB were trading on PE ratios of between 40-50 times, while high-yield, value-type stocks, such as BATs, were trading on PEs of 7 times to 8 times and yields of 7% and 8%. However, over the past few years there has been a compression of P/E ratios across the market and, therefore, going forward we would expect less of a differential in the performance of income and growth stocks.
Against this background, being in the right fund, one that is flexible and not locked into one investment style is critical. The advantage of our AA-rated UK Equity High Income fund is that not every stock has to have an above average yield. Currently, there is about a quarter of the fund that invests in stocks with a below average yield and this approach gives us more flexibility than others in the fund's peer group. While the fund must deliver 110% of the yield of the All Share index (to meet the IMA equity income sector requirements), every single stock is not subject to this requirement. This gives us a larger investment universe from which to add value, promoting diversification and the ability to invest in the team's best ideas - which may include stocks that are primarily driven by 'growth' considerations and have no or low yields.
Our 'focus on change' investment philosophy, aims to identify cheap stocks on improving fundamentals, which more recently has led to an emphasis on companies exhibiting a steady rise in earnings and dividend upgrades. In essence, we adopt a high conviction, bottom-up approach to portfolio construction by identifying situations where we believe the consensus opinion on a stock is wrong and where we believe that the outlook is improving. An example is Rolls Royce, where we went against the consensus view and bought the stock on a cheap valuation but where we felt the market was too pessimistic in terms of its earnings expectations. This stock then proved to be a highly profitable success story for the fund.
We use a range of indicators to discover strong stock stories, including company visits, earnings momentum and traditional valuation measures. Our UK equity team conduct full UK coverage in terms of research. Our larger companies sector analysts cover all stocks in the FTSE 350, and we also have a separate smaller companies research and investment capability. This gives us an important insight into those companies not as readily covered by the large broker houses. It also allows us more potential to focus on change and exploit our investment insights. Our size and profile as a UK equity asset manager, with around 2.0% of the UK equity market under our management, means we have superior access to companies - through both structured meetings and regular conversations with key decision makers.
This all adds up to a stock specific fund that is flexible but focused on robust ideas. It means you can achieve solid returns whether the market environment is focused on income or on growth. It is this approach that has allowed our UK Equity High Income fund to achieve top decile performance over one and three years* and to capture the attention of investors.
Key points
High level of dividend growth supporting income funds.
Bid activity set to continue.
Difference between P/E levels in growth and income diminishing.
Flexible investment style essential to maximise returns.
