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A wider yield of vision

In the last year, equity markets in the UK and globally have focused on spectacular rises and falls in the new economy sectors.

Telecom, media and technology stocks have dominated the market and the attention of institutional and private investors. These sectors have the potential for massive capital growth as new markets are expanded and companies exploit their business franchises to build market share.

However, in this search for capital appreciation, markets have ignored the traditional need for investors to receive income by way of dividends.

While high-growth com-panies should still focus their res our ces on growth, the dem and for inc ome from equity markets will remain strong.

What has changed is the challenge facing income-oriented inv es tors in an env ironment where the focus has been on growth.

This has certainly made investing for income more difficult, with old economy sectors suffering from significant selling pressure as investors raised cash from these sectors to invest in the new economy.

In the current market, there are challenges and opportunities for fund managers of high-yielding equity portfolios.

An indication of the extent of the problem facing income-orientated investors is that the yield on the FTSE All-Share index has fallen to 2.2 per cent, which is low by historical standards. One reason is that equities have performed well in recent years. Despite dividend increases, yields have fallen and, with the retail price index low, companies have felt they do not need to increase divid ends by as much as in the past.

A second, more telling, reason is that the nature of the index has changed. There are more new economy or high-growth stocks within the index and they retain a grea ter proportion of earnings to finance their future growth. Vodafone, the biggest com pany in the FTSE All-Share index, currently acc ounts for 8.8 per cent of the index but has a yield of only 0.5 per cent or about a quarter of the market yield.

In addition, many companies that have historically paid a high level of dividend have been taken over or have been taken private as their stockmarket valuations have fallen. The premium at which many of these companies have been taken private indicates that the underlying business model and earnings&#39 ability of many of these companies had remained strong despite the extremely low valuation that equity markets placed on them.

The extent of the selling pressure on high-yield stocks is evident in the relative performances of the FTSE 350 higher-yield index (which rep resents roughly the highest-yielding half of the FTSE 350 by market capitalisation) and the FTSE 350 lower-yield index (the lowest yielding half). Since 1985, the two sub-segments of the FTSE 350 index have tracked each other broadly in capital terms until the middle of 1999 when the FTSE 350 higher-yield index entered a bear phase and the FTSE 350 lower-yield index took off.

But there are positive factors as well. There have been good dividend increases from companies which have averaged 9.6 per cent a year since 1994, based on the All-Share index, and which are exp ec ted to grow by over 7 per cent in the next two to three years.

Analysts are predicting that dividend cover – the amount by which a company&#39s dividend is covered by earnings – will return to above 2x by 2001 after falling to around 1.8x from a level of 2.5x in the 1980s. The cover level indicates that, des pite some equ ity market prices, a company&#39s ability to pay dividends rem ains robust.

Individual companies can obviously increase their dividend payments by much more than the All-Share average on which the preceding numbers are based. It also can be very productive to inv est in a good-quality business with a reasonable yield and the potential to increase dividends substantially over time. This means that the running yield on the original investment is high but that, in absolute terms, both dividends and earnings will grow and, if the market rating is maintained, there will be capital upside as well.

There are also good quality companies in depressed sectors such as engineering, housebuilding and chemicals where average yields are above 4.5 per cent. There have been good dividend inc reases over a num ber of years and there is the pros pect of more to come.

While concerns have been raised over issues such as the strength of sterling for exp orters, especially engineers, a slowdown in the housing market and the impact of higher oil prices on chemical input costs, it seems unlikely that most companies in these sectors will see the kind of fall in earnings and cut in dividends that their current share prices would indicate.

Some companies will strug gle and it is always best to heed excessively high yields as an indication of trouble to come. However, many of these yields indicate the current fashion for growth investing, especially high-tech growth, rather than the sustainability of dividends.

While higher-yielding stocks are not usually growth stocks, investors can see capital gains for a number of reasons. Many higher-yielding stocks operate in cyclical markets and, therefore, are exposed to increase in demand as the cycle turns up. Oils, housebuilders, building materials and mining are all traditional cyclical sectors which also have high yields.

High-yield stocks can evo lve into different businesses, shedding less attractive divisions and expanding divisions with more growth potential – Marconi and Bowthorpe, for example – and so enjoy a subsequent substantial rerating.

These stocks may also be the subject of corporate activity such as bids from private equity funds or management, esp ecially if they are cash-generative businesses. Prices have been high relative to their market value before the bid app roach.

This is one of the attractive dynamics. Companies are gen erally focusing on improving shareholder returns, core businesses and establishing more effective capital structures. This can free capital for shareholders, too, in the form of special dividend payouts, buyback of shares and other forms of capital repayment.

While more companies are doing this, previous growth companies are maturing and transforming from a growth-oriented to a yield-focused company, providing further investment opportunities.

There is an interesting opportunity to find high-yielding equities in the shares of split-capital investment trusts. As these trusts are geared by bank debt and other forms of preferential capital, there is a good potential for capital uplift if the underlying assets of the fund grow sufficiently.

The flexibility of the split-capital structure means these funds have been able to offer investors the best of both capital and income investments. A number of trusts have a lowor zero-yielding growth port folio which may be inv ested in high-growth areas such as technology, media or biotechnology.

There will also be a high-yield portfolio invested in a combination of UK higher-yield equities, bonds or high-yielding investment trusts, which provides investors with a high initial yield.

While the higher-yield sector has recovered in part from its low point in early 2000, there is still some way to go. This should support a more positive outlook for higher-yielding stocks. The outlook is good.

As we have seen in the last few months, it is less than a foregone conclusion that internet and new-tech companies will dominate establis hed, older economy business models. This provides a further potential rerating of some of the UK&#39s high-yielding stocks.

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