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Mark Dampier: You just can’t beat equity income

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No other investment has endured like equity income. Regular readers will know I am a huge advocate of this strategy; its objective of generating both income and capital growth is precisely what most investors seek.

More cautious investors favour the security offered by cash deposit. This comes at a price, as seen over the past five years in a world of historically low interest rates, and – even further back –  since 1990, when interest rates peaked at 15 per cent. For many, interest paid on cash deposits can no longer be relied on to pay all the bills; the capital never increases and the rate of income is at the mercy of the Bank of England. 

Capital invested in the stockmarket will inevitably rise and fall. Dividends tend to be more stable; over a period of at least 10 years, while not guaranteed, one would generally expect dividends to rise. 

I view equity income as the ideal asset class for baby boomers starved of income, and even for the younger generation who can elect to reinvest income and compound returns over a longer period.

My suggestion would be to construct a portfolio of equity income funds, partly for diversification. Holding a number of funds could also increase the regularity of income payments.

I would highlight the Rathbone Income fund, managed by Carl Stick. It is fair to say he went through something of a baptism of fire between 2007 and 2009, leading him to take a fresh look at his investment process. Risk is now very much a focal point, of which Stick considers three main elements: price – the risk of overpaying for a share; financial – the risk of a company being overleveraged – that is, too much borrowing; and business – the risk of competition. There is also the effect of inflation, along with sheer bad luck.

In essence, Stick seeks quality companies with a market-leading position, while a low valuation can provide a buffer against unexpected events. He does not define risk as the potential for share price volatility; instead, he views it as the permanent loss of capital.

His five-strong analyst team reduces positions if the price risk (or valuation) looks too high although they aim to strike a balance and will not own low-quality stocks purely on the basis that they are cheap. In a toss-up between price and quality they will always err on the side of quality. 

They are also willing to take significant sector bets without concern over benchmark weightings. This is an important characteristic, otherwise the fund risks mirroring the benchmark index, limiting the extent for potential outperformance.

Exposure to medium-sized companies is being reduced. While Stick still views the smaller end of the stockmarket as an attractive hunting ground, he is taking profits following an exceptional run. The manager feels he can gain a better understanding of smaller businesses although quality is even more important in this area of the market. He will not invest in a company below £200m in size unless he views it as an exceptional business.

Sectors including utilities, oil and gas, consumer staples and food retailers continue to be avoided. Stick is turning his attention to the wider financial sector, including stocks such as Aberdeen Asset Management, Direct Line, Provident Financial, HSBC and BankUnited. 

The manager uses the fund’s ability to invest up to 20 per cent overseas although he will only do so when seeking exposure to a theme where there are no suitable UK-listed options.

To conclude, some investors continue to focus purely on the security of capital. Herein lies the problem; preventing the potential for capital growth means there is no chance of achieving a return greater than inflation, eroding the potential for any “real” return. 

A portion of any portfolio should always be held in cash for those rainy day emergencies. 

For those with a long-term investment horizon, I believe carefully chosen equity income funds can form the cornerstone of almost any portfolio.

Mark Dampier is head of research at Hargreaves Lansdown

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