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Growing pains

Equity income funds that focus on yield at the expense of growth are bound to disappoint

The equity income sector has been the darling of many investors in recent years but the love affair is under strain. This was beginning to happen even before the current turmoil as the average fund had markedly underperformed the FTSE All Share index over the previous year.

The reason for this is that producing above-average dividend yields and outperformance is not always easily reconcilable in all market conditions. The number of companies in the FTSE 350 index with a dividend yield above the FTSE All Share has markedly fallen in recent years.

Fewer than 100 stocks in the FTSE 350 have a dividend yield of over 10 per cent more than the FTSE All Share, meaning that fund managers who have stuck with a rigid big company dividend discipline have been corralled into fewer and fewer stocks. When those stocks do not offer genuine diversity of risk, the results could be horrid.

This has been the road that some in the income and growth sector have been going down. The mortgage banks, property companies and house builders are all closely correlated in performance terms, yet are sectors that provide some of the few stocks that meet the strict requirement of certain income fund managers. If the UK economy enters a severe housing-related downturn, the income growth mandate for some funds has all the ingredients for a disaster.

The answer for the funds is to ensure there is genuine diversity of risk in the stocks held. This can mean putting some money overseas but for the funds I run it is having long lists of UK stocks with an emphasis on smaller companies outside the FTSE 350.

For example, there are genuinely good dividend-yielding stocks to be found on the Alternative Investment Market. The smaller company recovery story can offer real value as these firms can be ignored by specialist small company funds which remain concentrated on exciting growth companies.

These stocks carry different sorts of risk but they bring genuine diversification. The long list of stocks is required so as to reduce stock-specific risk when buying recovery and smaller companies. These companies provide above-average dividend yields but, more important, have provided the portfolios with better capital and dividend growth over the cycle.

It is fortunate that the difficult period for income growth funds has come at a time when dividend growth for the market is strong. The funds’ relative yield can fall but the distribution can keep growing.

The fundamental point for investors to remember is that capital produces income. If investors want growing income in the future, the emphasis has to be on preserving and increasing the capital value. Once a manager starts chipping away at capital to produce income, the long-term consequence will be the diminution of both.

Big high-yielding companies that are not growing will prove poor investments over time, regardless of currently low valuations. Companies operationally go forward or they go backward – they do not mark time.

The UK is overbanked. There are not enough profitable opportunities to go around so banks are inclined to behave irresponsibly as they fight for market share.

The UK banking sector will have periods of good stock price performance but, in time, the banks are likely to be valuedestroyers. Income-orientated investors should not find themselves over-committed to the sector.

Imagination is required in stock selection to produce capital and income growth. It will not come from being herded into a small number of high-yielding big companies. Growth matters.

James Henderson manages the Henderson UK equity income fund at Henderson Global Investors

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