John Stavis, the manager of Fidelity's Income Plus fund, believes holdings should have a big enough position to impact on a fund's performance or shouldn't be owned at all
Equity income funds have long been popular with investors, but the manager of Fidelity's Income Plus fund, John Stavis, believes they are now playing an even more important role in the provision of total returns as stock markets continue to drift in a low-growth environment.
Stavis says dividends are already accounting for up to 40% of overall returns in a market that is nowhere near as positive as it was back in the booming 1990s. And he is also confident that his focus on higher-yielding stocks hailing from a variety of sectors will provide a far smoother ride for investors - regardless of what happens in the global economy.
"This fund is distinctive because it is a research-driven product which is constructed of largely uncorrelated stocks, without either a thematic bias or a significant small-cap focus," says Stavis. "I'm trying to avoid low dividend-yielding stocks because I want every holding in the fund to contribute to yield. This should also have the effect of lowering volatility."
The stated aim of the Income Plus fund, which is A-rated by Standard & Poor's (S&P), is to achieve a combination of income and long-term capital growth from a portfolio that is primarily made up of UK investments.
Typical investors likely to be attracted to the fund, suggests Stavis, is anyone requiring a less volatile approach to equity investing and possibly someone who is in a slightly older age group, but not yet at the stage where they require a consistent income over time to meet living costs.
"It's going to be a person who wants some sort of income and less downside risk," he explains. "However, they will still be young enough to be able to take some risks and enjoy the equity upside."
Stavis assumed full control of Income Plus at the beginning of the year and wasted little time making his mark on the fund. His first move was to cut out the majority of the small-cap names, which is exactly the same approach he adopted when he took over Fidelity's Growth + Income fund 14 months earlier.
"I don't want my funds to have a 'tail' of small stock positions because these can dilute the performance of the larger names," he explains. "I believe a stock should have a big enough position to impact on performance or it shouldn't be owned at all."
Stavis also wanted to avoid competing with respected in-house funds that already offer exposure to small-caps and was keen to illustrate the fund's potential to grow in size and stature. "It demonstrates that a fund without small caps is actually very scaleable," he explains. "This provides a much more rigorous argument for building a distinctive franchise."
The second major change Stavis made to the fund was to sell almost every holding that yielded less than around 2.5%. "There were a couple that yielded less, but virtually all have gone now," he recalls. "The current dividend accrued is about 25% more that it was last year."
A number of foreign names have also been added to the fund. "The fund has about an 8% weighting outside of the UK," explains Stavis. "I look for equivalent companies abroad that are either trading at good valuation discounts, have a higher dividend or are performing better, faster and cheaper."
These changes have trimmed the number of holdings from 80 to around 65 and Stavis expects this figure is likely to remain stable going forward. "When I inherited the Growth + Income fund, it had about 126 names, which I quickly cut down to 75," he recalls.
When Stavis looked back at the fund after three months, he was surprised at how the portfolio had been transformed. "I didn't think I'd made that many changes, then realised there were actually significant differences," he admits. "It has been a fairly gradual transition process, but the fund is now being run very differently to before."
S&P was quick to pick up on the changes Stavis planned for Income Plus when the rating agency issued a report in February - just a month after he had taken over the hot seat.
Praising the "personal flair" Stavis had demonstrated during the year he had already spent in charge of his other fund, S&P said it took comfort from his "well-thought-out stockpicking approach", which was praise indeed.
"He [Stavis] tends to view companies over a different time horizon to most, confident that strong fundamentals will ultimately prevail," read the report.
His subsequent performance appears to have justified that assessment: since the beginning of January 2004, he has delivered a bid to bid return of 14.75%, placing him 10th out of 79 in the UK Equity Income sector, according to data compiled by S&P as at 8 November. The figures are comfortably ahead of both the 11.25% average return for the sector and the 9.88% achieved by the FTSE All-Share index.
Over the past six months his performance has been even more encouraging. The Income Plus fund is ranked an impressive fifth out of 79 in the UK Equity Income sector, according to S&P figures as at 8 November. The 9.69% bid to bid return achieved since 10 May exceeds both the sector average of 7.22% and the 7.07% recorded by the FTSE All Share Index over the same period.
To what does Stavis attribute his success? "It's down to the names in the fund," he says. "If I look at what has been driving the relative performance it has been very good stock selection, and part of that is from the foreign names. The stocks I hold come from different sectors and this is a vital factor."
Income Plus is constructed through bottom-up stock picking, with Stavis applying a contrarian approach to stock selection that consists of focusing on out-of-favour companies that seem inherently undervalued.
He then decides on an investment horizon which is typically different to the market's - in most cases longer, but sometimes shorter - with cashflow and earnings yield relative to growth potential both major factors in his decision. "The first attribute I look for is that a stock has to be cheap," comments Stavis. "Valuation really does smooth over a lot of other issues."
He recalls a sign that used to hang over a colleague's desk which read: 'Fast, clean and cheap - pick any two'. This, he believes, perfectly illustrates his approach.
"I recognise you're not going to get a stock that's fast, clean and cheap at the same time," he says. "This would mean it was growing quickly, had an impeccable management track record and was also cheap."
The reality, he adds, is that if you buy something cheap then, by definition, it's either not growing fast or has suffered some kind of stumble in the past. "However, if you buy something at an attractive valuation it shows you're not going too far wrong," he points out.
The next most important factor is the company's cashflow position. "I always like to see where the cash is going," explains Stavis. "If a company is paying out a reasonable yield, is re-investing in what I think is a suitable way, and is fair or cheaply valued, then it will be a candidate for the fund."
The management behind a business is also vital. "I want to see a logical strategy that I can follow in order to construct an investment thesis," says Stavis. "If the management doesn't come out with such a strategy then I'll become suspicious and will be unlikely to buy the stock."
So which area of the market does Stavis scour for suitable investment opportunities?
"Basically, I'm looking at anything in the FTSE 350 Index, as well as foreign issues," he explains. "For Income Plus I can't imagine buying a stock that yields less than 2% and this obviously reduces the number of names I can consider."
However, the fact the fund is not benchmark constrained - another crucial element of his approach - provides Stavis with the flexibility to buy stocks that have better potential to rise in value. "If I'd have only looked for growth last year in my other fund, then I'd have missed out on quite a few names which added to the overall performance," he points out.
One stock that epitomises his approach to the fund is British American Tobacco. "I have owned this company for a long time as the total return is comfortably in double digits," he explains.
"It's trading on about 11 times its earnings, is on about a 5% dividend and is buying back about 3% of its shares every year. It also has the potential to cut costs in its business."
In his quest to discover such opportunities, Stavis is in the enviable position of having the back-up support of Fidelity's team of 78 London-based analysts - among whose ranks he spent his formative investment years. "They are all very high quality and excellent sources of information," he says. "They are usually my first port of call and, even if I don't personally agree with all their recommendations, the background work they carry out on companies is crucial in helping me to reach my investment decisions."
As well as the analysts themselves, Stavis also has access to a wide range of analytical tools - both proprietary and off the shelf - that provide a depth of detail that he uses to form a judgment on companies and management teams.
The back-up support also enables Stavis to make his investment decisions in a methodical way. "I've got a list of around 300 stocks that I believe are potential candidates for the fund," he explains. "I update this list on a regular basis and keep track of what each company is doing." This constant questioning - of changes in strategy, growth and environment - is essential to ensure he is maximising his potential outperformance. It also, he says, gives him an edge over rivals.
"Fund managers who do not have access to such resources will be forced to work on a more thematic basis," he explains. "This means they'll have three or four big ideas driving performance. That's fine if everything goes well, but if they're wrong on a couple of ideas then they will have a very rough year."
Another way Stavis seeks advantage is by light trading. "I don't like to pay stamp duty," he admits. "If I can avoid it by trading the fund less but still take advantage of my investment opportunities, then that's what I'm going to do."
The fund's turnover rate, therefore, hasn't been excessive so far, although during the first three months it was far higher than normal as Stavis altered the make-up of the portfolio. "If the turnover was below 50% or over 100% then I'd be surprised," he says. "It should usually be somewhere in between, depending on the market conditions."
Stavis will normally look to sell when a stock reaches his price target, although this obviously depends on circumstances. If, for example, the market is taking a closer interest in the stock, he'll hold on to maximise his profits.
"I set price targets based on a variety of factors that don't change often and tend to work well for me," he explains. "If a company is trading on a reasonably high multiple but is in a sector where a very strong pricing environment is unlikely to continue, I'll probably sell when it hits my price target."
Stavis appears to be so comfortable in his role that it is hard to believe he's been a portfolio manager for just over two years. As is the Fidelity way, he has worked his way up through the company since joining as a research analyst in 1995.
Quickly identified as a potential high-flier, he became an associate portfolio manager with responsibility for the Europe, Middle East and Africa equity portions of the Global Emerging Markets portfolios.
His active stock picking ability was recognised and he worked closely with Anthony Bolton on UK companies during 2002 before he was handed control of his first vehicle, the Fidelity Growth + Income fund, in October 2002.
However, Stavis certainly hasn't rested on his laurels and, as well as taking over at the helm of Income Plus fund, has also assumed responsibility for managing the equity portion of Fidelity's Moneybuilder Balanced fund.
His success vindicates Fidelity's recognised policy of identifying the potential fund management superstars of the future from within the company's own rich vein of talent and promoting them up through the ranks.
Typically, Stavis remains modest about his achievements. Working as a research analyst, he says, equipped him with the skills required to analyse a company's financial position.
"As an analyst you are always interacting with fund managers and the rate at which you learn new skills is incredible," he explains. "During my career at Fidelity, I have been able to obtain an extremely comprehensive and interesting view of a wide range of industries and balance sheet issues."
And he plans to continue using those skills, and his distinctive approach to investment, to deliver top drawer returns for his investors.
"The reason people buy an equity income fund is the discipline it imposes on the fund manager to buy stocks cheaply and sell them more expensively," explains Stavis. "By owning stocks that are higher yielding you can create a fund which will give you good performance in the better times together with a measure of downside protection in the weaker years."
