Aaron Barnfather, manager of Newton's newly launched European Higher Income Fund, focuses in on some of the unique opportunities that are now available to two European equity income investors
The news that Europe is moving towards an Anglo-Saxon corporate culture is beginning to permeate the UK investment industry. European equity markets offer a level of yield that is at least in line with that of the UK - the traditional home of equity income investment - while at the same time offering far higher rates of dividend growth.
As a specialist in equity income solutions, it's news that is especially welcome for Newton as there's no denying that Europe now offers one of the broadest spreads of blue-chip, high-yielding companies anywhere in the world. The same cultural strides that have brought European markets to their current position also mean that there have been few times in their history when they have corresponded so well to Newton's thematic investment approach - the process by which we prioritise our in-house investment research.
Europe's thematic drivers
Today's Europe is rich in stocks that correspond with one or more of Newton's investment themes. Especially prominent for income investors is Newton's theme of the 'networked world'. This encourages Newton's analysts to focus upon those opportunities that arise from the much increased connectivity of people and businesses thanks to the expansion of telecom services. Other core themes include concepts such as 'debt and credit' or 'developing economies'. The former is predicated on levels of western debt continuing to grow faster than GDP and prompts our analysts to avoid highly leveraged UK and US consumers and instead target those in less leveraged and sometimes less mature markets. The driving force behind 'developing economies' meanwhile, again emphasises opportunities in markets where incomes and workforce numbers continue to rise.
There are few better illustrations of this thematic approach than that represented by Telefonica O2 Czech Republic - a play on our theme of the 'networked world'. Its shares currently trade at a significant discount to its Western European peers, with a dividend yield of over 9%, while also offering growth potential. Its business is 50% fixed and 50% mobile telecoms but as the Czech Republic only has 33% fixed-line penetration, the rapid spread of broadband has made it one of the only companies in Europe in the process of extending its fixed line infrastructure. Although the Czech Republic offers room to grow, the business is also rapidly expanding into Slovakia, providing another leg of expansion.
Their strong earnings and thematic appeal therefore makes telecom stocks a key component of the Fund. While including France Telecom and Telecom Italia, which currently yield 5.9% and 7.8% respectively, the Fund also includes Cosmote, a mobile telecom business that enjoys a dominant position in new EU states such as Bulgaria, Romania and Albania, providing a significant degree of overlap with our theme of 'developing economies'.
Elsewhere, the Italian blue chip bank Unicredito is another significant overweight in the European Higher Income Fund and one that chimes with our theme of 'debt and credit' and 'developing economies'. Like many of the Fund's top holdings it supports our bias toward stocks with strong cashflow and transparent earnings. As the leading bank in Italy it benefits from Italian lending and mortgage debt still being at relatively low levels while, most importantly, it has just bought Hypoverinsbank in Germany. This acquisition gives it access to the recovering German business and property market, while also allowing it to consolidate its lead in Eastern European banking. Other high yielding banks in the Fund include France's BNP Paribas, the rapidly progressing Greek bank EFG Eurobank and KBC of Belgium, which also continues to enjoy a leading position in Europe's prosperous emerging markets.
Of course, with so much potential on offer for today's equity income investors, the only way to really prosper is to have a reliable way in which to navigate Europe's varied markets.
Universal appeal
This is where the yield discipline that underpins each of Newton's equity income funds comes into its own. In the case of Newton European Higher Income Fund, our global research process defines those stocks that offer strong fundamentals, attractive valuations and which are supported by positive trends. Newton's income process then refines the universe further (see Chart 1). This discipline requires that any new holding must offer a prospective yield 15% greater than that of its domestic equity market, while any stock whose yield falls to market levels is immediately sold.
This drives a sentiment contrarian approach and forces significant stock voids. In doing so, it narrows the index from 378 to only 140 or so stocks, but by scouring the wider universe, this potential universe rises to closer to 400 stocks.
By ensuring that each and every portfolio holding delivers a high yield, the Fund represents a uniquely disciplined proposition that targets a gross yield of between 4% and 4.4% currently. It also delivers a portfolio with true 'value' credentials with a lower average P/E (12.4x) than the FTSE W Europe ex UK Index (13.9x) but with a 40% higher yield and higher levels of dividend growth. Meanwhile, Newton's unique sell discipline means that capital is constantly recycled from those stocks that have already made strong progress to those best placed to do so - frequently allowing the Fund to book all of the profits on a strongly performing stock, even while competing funds may be restrained by index considerations. With signs that global growth and earnings could well face headwinds from here, such yield discipline might be just as well.
