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Ammunition check

Adrian Frost joined Artemis nine years ago after almost two decades at Deutsche, attracted by the opportunity to focus entirely on running money.

In the period since, his £3bn-plus income fund has consistently been among the most popular in a competitive sector while the bond-focused high income has also built a strong following.

Frost has been managing income portfolios since the mid-1980s and says a key realisation is that while yield is a great measure of value, it should not be the sole element in stock decisions.

“Dividend is typically the last decision made in the boardroom and so picking companies should not rest entirely on something so discretionary,” he says.

Frost and co-manager Adrian Gosden focus on a company’s ammunition to make distributions – namely cashflow – and investigate potential payouts post-capex, tax and interest.

Another factor in choosing companies is their general belief in the idea of transmitting cash to shareholders rather than thinking that it effectively belongs to them.

Looking at the current UK dividend picture, Frost says things are improving slowly but he feels that the yield concentration in a few large-cap stocks remains problematic.

“We have used our 20 per cent overseas allocation to counter this but, overall, we want the income fund to be an economic expression of where we see cashflows and dividends going. With BP at 8.5 per cent of the index, for example, going overweight in that stock basically means assigning 10 per cent of capital to one position. At present, 26 per cent of the UK market yield comes from the oil sector, which is clearly an issue when stocks are underperforming.”

Generally speaking, Frost highlights astonishing cash generation over the last 18 months by companies cutting costs and is encouraged by current balance sheet strength.

“We would like to see some of this cashflow coming through in dividends as we see that as the least dangerous way of deploying it. The risk is that certain companies might get tempted to be more aggressive with this cash and take the M&A route, which we consider more dangerous.”

While certain companies have come back to the dividend list this year, Frost says this remains a cautious return, with distributions at 10 per cent or 20 per cent of previous levels for the most serious cutters. Most of the yield concentration issue has come out of banking problems, with several forced to suspend or cut dividends to repair their balance sheets.

Frost splits the sector into two, seeing investment banks as hard to analyse as it is tough to predict levels of future trading and therefore dividend sustainability.

The other part of the sector – traditional clearing banks such as Lloyds – are currently suffering from not being boring enough, according to Frost. “These stocks should be utility like, with slow growth each year, but many have lent unwisely and tried to expand too quickly.”

He currently has around 6 per cent in banks, with positions in HSBC and Lloyds.

As for the miners, Frost feels their earnings profile looks unsustainable unless you are a raging China bull.

“We like things with good sustainable cashflow profiles and that makes the mining sector a hard place to invest. Holding these stocks would have helped recent performance but I feel some managers own this sector just to get close to the benchmark and that is not how I run money.”

Frost’s high-income portfolio – also run in partnership with Gosden – largely invests in bonds, with a potential 20 per cent equity kicker. While primarily known as equity managers, he feels they can use their skills to pick bonds, with the same company cashflow and balance sheet used to service dividends and coupons.

Current key positions in high income include a 7.5 per cent stake in fund management company bonds, which the team sees as lightly geared and cash-generative, with enough margin safety to thrive in tougher conditions.

GlaxoSmithKline is among the biggest equity holdings, with the managers high-lighting its 10 per cent free cashflow yield while trading on a 20-30 per cent discount.

On the macro front, Frost says the upcoming election is unlikely to have an impact on corporate cashflows but acknowledges growing pessimism on the Government’s ability to improve its debt burden. He says: “Bigger risks are obviously a sovereign debt crisis or a strong resurgence in inflation although most central banks fear deflation more and would welcome some inflation to help solve deficit issues.”

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