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The best offence is a good defence

James Smith reports that even income stalwarts are erring on the side of caution after a troubled time in 2009.

Several high-profile UK equity income funds suffered a frustrating 2009, with most of their preferred sectors left behind as cyclicals led the post-March rally.

Some income portfolios have kept pace with a rapidly rising market, although average returns over 12 months to January 11 were 24.3 per cent against 31.6 per cent from the UK all companies sector.

As background, dividend cuts across UK companies have curtailed options for income managers, causing concerns over clustering in the stocks able to maintain distributions. This situation is largely down to financials, with several banks forced to cut or suspend dividends as they attempt to repair balance sheets.

With banks stripped out, more than two-thirds of the UK market dividend comes from 15 stocks – including BP, Royal Dutch Shell, Vodafone, Astrazeneca, GlaxoSmithKline and British American Tobacco – and these appear in the majority of portfolios.

Despite this, there remains a 40 per cent performance gap between the best and worst income funds over 12 months, showing managers are adding value outside these mega caps.

Several also predict an improving dividend environment in 2010, with many companies having repaired their balance sheets.

Much of the recent press attention has focused on Invesco Perpetual’s Neil Woodford, whose multibillion income and highincome funds are enduring a rare spell at the bottom of the peer group.

Woodford said this is largely down to the market’s rapid embrace of early economic recovery signs, which saw the cyclicals hit hardest
in the downturn and then recover sharply.

He says: “My portfolios have remained focused on areasthat will do well in a challenging environment but the market has largely ignored these on the view that they will underperform in a recovery.

“Corporate performance from these quality growth stocks has been strong but there are points where share prices diverge from fundamentals and we feel this happened last year.”

Woodford now believes that valuations on many cyclical areas look stretched, anticipating not only a V-shaped economic recovery but also profits and cashflow they cannot deliver.

“We always felt the macro picture would stablise, given the scale of monetary and fiscal support, but the economy is still some way from being able to deliver independent growth.”

’2009 was a poor period for dividends and wiped out the growth seen over the previous few years but several companies have now repaired balance sheets and profitability and cashflow are improving’

Based on this view, Woodford has kept faith in sectors such as utilities, tobacco, pharmaceuticals and telecoms, which offer sustainable business models, reliable earnings and rising dividends.

These areas were de-rated last year but Woodford believes the situation will reverse in 2010 as the market grows cautious on cyclicals’ ability to deliver and refocuses on fundamentals.

While acknowledging widespread dividend cuts across the UK, Woodford said his favoured areas are best placed to grow their distributions, as well as being the cheapest.

On banks – previously the major hunting ground for income investors – he feels the period of crisis resolution has years to run and stocks will
struggle to deliver profitability assumed in share prices.

PSigma’s Bill Mott, another income veteran, shares Wood – ford’s general caution, altho – ugh he believes a double-dip can only come through serious economic mismanagement.

He says: “So far, all the various fiscal and monetary measures have delivered stability and gentle recovery by bringing forward spending from tomorrow to today. But the bond market will force the Government to adopt a more prudent approach following the next election and we feel quantitative easing should be withdrawn.

“As long as ministers apply fiscal tightening correctly to rebalance things, the econ – omy will be slow enough to preclude rapid interest-rate
rises and we should be in for a long period of sedate growth.”

Against this tough background, Mott has taken a barbell approach on his PSigma Income fund, buying high-yielding stocks as well as growth opportunities.

At the high-yield end, the manager is holding defensive companies with strong cashflows, which he expects to be re-rated as incomehungry
investors move away from bond markets.

He says: “Companies that have maintained or increased dividends during the last two years are very unlikely to cut them now the recovery has
begun, and several currently yield significantly more than 10-year gilts.”

These stocks are found in pharmaceuticals, telecoms, utilities and tobacco – all sectors currently favoured by Woodford.

Meanwhile, with the world in a low-growth phase, Mott believes companies that can grow faster than average will be easily identifiable and also enjoy a re-rating.

The other end of his portfolio is in this type of stock and Mott draws comparisons with the nifty 50 era in the 1960s and 1970s, when 50 US large caps led the market and rewarded a buy-and-hold strategy.

Robin Geffen’s Neptune income fund has been among the sector’s stronger performers, benefiting from financial positions as well as some energy plays in overseas markets.

He has recently cut back the financial exposure, however, as regulatory concerns overshadowed the sector and it lagged in the final months of 2009.

Geffen also notes sector rotation into large caps late last year with the market beginning to discount an uncertain domestic outlook, and Neptune income gained from its 75 per cent position in the FTSE 100.

Geffen says: “Looking to 2010, the FTSE 100’s strength is likely to continue, yet we believe this will disguise a much wider range of outcomes
across the market than in 2009 and there will be a need to pick sectors and stocks carefully.

“We believe dividend yields will form a large component of total return this year – as they have done historically – and will continue to ensure
every stock in the fund contributes to income.”

LV= UK equity income manager Graham Ashby is also positive on dividends this year, with companies including Barclays and Carnival returning to the ranks of payers.

That said, he believes several stocks that have maintained distributions may be facing strategic problems and is avoiding many of the typical
income fund stalwarts.

Ashby’s portfolio does not include HSBC, Vodafone or GlaxoSmithKline, for example, highlighting mounting margin pressure among many blue chips.

Ashby says: “In general, 2009 was a poor period for dividends and wiped out the growth seen over the previous few years but several companies have now repaired balance sheets and profitability and cashflow are improving. Our caveat to that is in stocks like Glaxo and Vodafone, where margin pressure will feed through to free cashflow and could limit future distributions.”

Overall, Ashby sees the UK as reasonably fair value, although it remains cheap compared to other developed markets, and he highlights opportunities in several more defensive mid-cap areas.


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