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Learning on earnings

Throughout the 1990s, the UK economy moved into a low-growth and

low-inflation environment. This was good news for UK markets but investors

had to live with a dramatic fall in equity and bond yields.

It would have been easy to conclude that an equity income fund might be

regarded as a contradiction in terms but this sector remains one of the

most popular in unit trusts.

Equity income managers aim to identify and invest in companies which are

capable of growing dividends.

In the UK equity market, a company&#39s dividend is seen as a key signal on

its fortunes, with the income providing an important part of total returns.

As a company&#39s earnings grow, cash should be generated which finances

further growth in the business and in the dividend. The dividend cover

(earnings per share/dividends per share) provides a measure of the

conservatism of the dividend.

A growing, prudently financed dividend should therefore be allied to a

rising share price driving total returns for shareholders.

An alternative method is to identify stocks with high running yields.

While this method has its supporters, our view is that macro-economic

change does not favour this type of stock. In an era of high inflation,

companies could use nominal price increases to drive nominal dividend

increases even though real returns could be negative. In many cases, these

companies had low dividend covers reflecting the lack of capital needed in

the ongoing business.

The main chance of capital returns came from a step-change in the

company&#39s fortunes, either through management change or corporate action,

which was not always forthcoming.

As inflation has receded in developed economies, real growth has become

increasingly the driver of equity returns. Many companies with high yields

and low covers have cut dividends.

The other fundamental change has been in UK taxation where the treatment

of income versus capital returns has been substantially equalised, most

notably through the abolition of the advance corporation tax credit.

The corollary is that companies with higher growth tend to have lower

yields as stock valuations are higher and more cash is reinvested for

future expansion.

The abolition of the ACT credit, combined with the long running equity

bull market, has resulted in a lowering of aggregate equity yields.

To enhance yields, some UK equity income funds use fixed-interest

securities, predominantly convertibles, to increase total income while

still offering the prospect of capital appreciation as the underlying

equity grows.

A close look at the recent economic background, along with the strategy

employed in our extra-income unit trust, helps illustrate some of these

points.

The turn in the interest rate cycle since September, with the Bank of

England raising interest rates by 0.25 per cent on four occasions,

triggered a change in the stockmarket&#39s favoured sectors.

Enthusiasm for interest-sensitive assets waned, with price falls in

sectors such as engineering and housebuilding. The fund had previously

raised significant profits from such stocks and, given the sound long-term

prospects, remained involved in these sectors.

In the fourth quarter of 1999, there was an unprecedented surge of

interest in technology-related investments. Attention was focused on

investments likely to benefit from the switch in economic activity to the

internet and the explosion in mobile phone use.

Not only did investors chase these new stocks but, to fund such purchases,

many established securities were sold down to very depressed levels.

This background produced a stark dichotomy between low-yielding equities

and average and above-average-yielding equities.

While the FTSE All-Share index rose by 11 per cent in the six months to

March 31, the FTSE 350 higher-yield index fell by 4.7 per cent and the FTSE

350 lower-yield index rose by 24.7 per cent.

In a short space of time, a massive divergence between these indices

emerged, although the recent wobble on the Nasdaq has seen this gap close.

While many new economy stocks have no earnings or dividends, resulting in

blue sky valuations, there are a growing number of companies with yields

nearing, or exceeding, their price/earnings ratios.

The fund has increased its position in fixed-interest and convertible

stocks which now account for almost 30 per cent of the portfolio.

For example, an investment in cable company Telewest through a convertible

issue was rewarded when a merger with Flextech, a content provider, saw the

price return 40 per cent.

In addition, the convertible bond produces a yield when the underlying

equity has no dividend stream.

In the equity markets, there is increasing concern about valuations

accorded to new economy stocks with short company histories. There is a

realisation that some younger companies may not have strong enough business

models ever to generate adequate revenues.

Many established companies have sound e-commerce strategies and investors

are becoming more discerning.

Using the past as a guide, some stocks have fallen to levels which appear

to undervalue future earnings and dividend prospects significantly.

Assuming they continue to deliver good results, then eventually their share

prices should better reflect their true worth.

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