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Nifty thrifty

The year has barely begun and already it looks set to be a good one for income-producing vehicles, with providers lining up with Isa offerings.

While the plethora of absolute return vehicles being launched will undoubtedly do well during the Isa season, income funds and products are likely to be just as popular, if not more so as they are have more proven track records.

The phrase “historic low interest rates of 0.5 per cent” has quickly become well worn but it looks unlikely to change anytime soon, as shown by the move last week by the Bank of England to maintain rates at their current level.

However, low interest rates are not the only reason that income funds are likely to strike a chord in 2010. Fund managers are looking for solid and dependable holdings and the same can be said for investors.

The large-cap and somewhat defensive nature of the typical company targeted by equity income funds is expected to fare the best this year as the macro economy continues to look uncertain.

Companies with improving profits and robust balance sheets able to continue their dividend payments are the mainstay of the income manager but even main- stream growth managers are targeting such stocks.

Equity income tends to be the fund pick of choice when markets are down, as investors seek the safety deemed inherent in the more value-oriented mandate of these funds. But maybe that is a difference with the forecast popularity of income funds – today, they seem to also offer some of the best growth opportunities.

Although cyclicals and smaller companies fared well in the early stages of the stockmarket rally, many managers believe it is large, solid companies that are set to grow the most.

Newton’s global higher-income manager James Harries says his fund lagged during the third-quarter rally as it never owned those stocks that fared the best as they were the ones beaten up in the credit crunch. But he anticipates that will not be the case for him in 2010 and maintains his preference for larger companies with strong balance sheets, reliable dividends, sustainable franchises and some exposure to growing emerging markets.

He says: “Ironically, it is these ‘boring’ industry giants that were left behind by the recovery of 2009. To us, that just increases their attraction as we believe they stand to make substantial gains once investors begin to recognise their appeal.”

PSigma income fund manager Bill Mott decribes his income fund as well positioned during such economic uncertainty. “Those UK companies that have maintained or increased their dividends during the last two years are unlikely to cut them now the recovery has begun.

“A key theme for the next 12 months is that investors will become yield-hungry. A number of larger companies currently yield significantly more than 10-year gilts and we believe these will undergo positive re-ratings. Their yields will gradually fall as share-price appreciation delivers capital growth.”

Mott’s favourite stocks right now are in sectors such as integrated oils, pharmaceuticals, telecoms and utilities. He believes UK companies that can deliver growth in excess of the average will be re-rated in a return to the nifty 50 style of the 1960s and 1970s when the top 50 most popular large-cap stocks led the market and rewarded a buy and hold strategy.

Neil Woodford, manager of Invesco Perpetual’s flagship income funds, underperformed his peer group in 2009 because he chose not to buy into the strength of the recovery story and avoided cyclicals. He does not believe his stance was a mistake and feels that last year the market ignored the fundamentals.

The situation has to reverse this coming year, says Woodford, and he will be in a position to recoup that relative performance.

He remains unconvinced as to how embedded the recovery is and believes it will be a long process, with markets set to experience several wobbles. As to whether or not there will be a steep correction, the Invesco manager agrees there are pockets of over-valuation but notes there remain pockets of undervaluation, meaning market numbers do not look stretched.

“I continue to focus on businesses that will do well in a tough economic environment and they just happen to be the cheapest stocks at the moment – you don’t often find that.”

Like Mott, Woodford is bullish on sectors such as pharma, food retailers and utilities. “I expect the market will recognise the strengths of the utilities’ sector, particularly when corporate performance is going to disappoint more generally. Yields and share price will rise in these stocks as they are far too cheap.”

With regard to what will prompt investors to change direction, Woodford compares searching for an individual catalyst with looking for a unicorn. “Many have heard of them but no one has seen one. Investors need to focus on valuations and companies best suited to the macroeconomic environment. It will become increasingly difficult for markets to continue to ignore the fundamentals.”

Gary West and James Inglis-Jones on Liontrust’s First Income fund hold a similar view, believing value styles should perform well and investors will become more discerning. “It is likely to become much more important for companies to justify higher investor expectations by meeting their profit expectations.”

Woodford is optimistic about dividend growth in his fund. His portfolios were booted out of the equity income sector last year and put in the new income and growth category because he was not meeting the IMA’s criteria of achieving a yield of 110 per cent of the FTSE All-Share.

But that is no longer the case. The manager says the yield on his funds is around 4.2 per cent, about 20 per cent higher than the market, and he expects this will go even higher this year, rising by an estimated 10 per cent. Woodford believes the UK offers some of the best opportunities, saying it is “as attractive as I can remember in my career”.

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