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High hopes

Mark Dampier
Mark Dampier

The most popular asset class with investors recently has been bonds. It has been this way for some time, particularly in the US. I often think popularity is a warning sign. The more people who buy into an area, the more fashionable it becomes and this can lead to overpricing. Yet with many expecting interest rates to remain low, on this occasion, I think the popularity could be warranted for the time being.

Government bonds have been in a bull market since 1990 when UK interest rates were 15 per cent and this long-term trend could have further to run. However, the longer it does, the more risk there is and a contrarian investor would probably now look to other asset classes for returns, notably equities.

True, equities have generally failed to perform over the last decade – largely because they were overvalued 10 years ago. I feel this is far from the case today and one area I am a fan of is UK equity income.

These funds have been through a challenging period over the last two years, given the nature of the recession, although looking at Newton higher income over 15 years, I note the annualised return has been 9.4 per cent against a sector average of 6.9 per cent and the FTSE All-share of 6.4 per cent.

So despite a difficult time, Newton higher income has given a pretty good total return. In fact, this is often true of high-yield equities generally against their lower-yielding counterparts. Total returns for high yield are 10.8 per cent per year against 7.7 per cent for the low yield index and 9.2 per cent for the market. And that is for a genuinely long period of more than 100 years. But for some reason investors tend to underestimate the importance of dividends and prefer to focus on the latest growth story.

That does not mean high-yield stocks are without their difficulties. Like most equity income funds, Newton higher income has suffered from BP’s dividend cut this year. What manager Tineke Frikkee did not expect was the previously declared dividend to be cancelled too, meaning three dividend misses in all. As a consequence the benchmark yield on the FTSE dropped to 3.2 per cent, which actually enabled her to add new names to the portfolio. Newton looks at the benchmark yield on the index and only invests in shares trading at a premium to it. With the index yield dropping, Tineke was able to buy Tesco, HSBC and Next, each of which Newton’s analysts rate highly.

This fund adopts a classic equity income technique – buying shares on a high yield and selling them once they become more fashionable and the yield drops below the benchmark. There is effectively an enforced discipline in buying low and selling high.

The loss of dividend from BP has meant a cut in payouts from many equity income funds. However, Tineke has more than made up for it elsewhere with income from other stocks. In fact, she anticipates increasing the fund’s income by a small margin this year. She has also sensibly kept her BP position and she expects the dividend to be reinstated next year.

With a yield of 7.3 per cent, the fund is providing a tremendous return in the form of income, considerably ahead of government bonds and comparable with many corporate bond funds. However, unlike a bond fund, this income stream should rise over the years as dividends increase. I see no reason why high-yielding shares should not also provide capital growth, as more investors become attracted to the regular income on offer and push up prices.

Tineke is not wildly bullish about economic conditions but she believes the companies in her portfolio should remain resilient. Top-line growth may be hard to come by but she expects to see more merger and acquisition activity and I suspect this will keep the market moving.

Do not give up on equities, particularly the high-yield part of the market. Whether you want the dividend income or not, it is part of your overall return – and a part that is becoming ever more valuable in the current low interest rate environment.

Mark Dampier is head of research at Hargreaves Lansdown

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