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Yield of dreams

Generally speaking, UK high-yielding shares have had a torrid time during the past year or so. Funds that specialise in this area have had one of their worst years since the end of the last century.

Part of the reason is that the credit crunch has led to severe underperformance of banking shares, which make up a big part of the high yield index. By contrast, compan-ies in the mining and energy sectors – which rarely yield anything – have performed extremely well but of course most income funds would have had little exposure to this area.

This has not stopped the buying of Neil Woodford’s funds but many others have fallen out of favour.

An early casualty was Liontrust first income. The fund had an incredibly strong run from 2003 for a couple a years, but since then its pace has slowed and it has fallen behind many of its peers. However, I feel that brokers should reappraise the fund now. Given the philosophy of the manager, we could see a sharp pick-up in the fund’s relative performance.

The twin objectives of an equity income fund are to increase both capital and income. This makes them a crucial investment tool for anyone with an eye on retirement. After all, when you retire you want the potential for your income to grow because everyone knows that the essential bills such as council tax, utilities and food are going up like a rocket.

Liontrust first income currently has an attractive yield in the region of 6 per cent and, perhaps most important, Jeremy Lang (the fund manager) expects dividends to increase by up to 10 per cent this year.

Lang’s investment approach is essentially focused on identifying companies that are being undervalued by the market. He identifies three main categories, which he calls “boring”, “ugly” and “unfashionable”.

The unfashionable companies are those that he considers to be good companies but where the market is currently pricing them as though they are an average company.

Boring companies are average ones that are being valued as though they are poor, whereas the ugly firms are those that Lang acknowledges as being poor businesses, but where the market is still undervaluing them.

As you might expect, this last category tends to be the smallest element of the portfolio.

Pessimism rules in the markets, perhaps exacer-bated by the activities of hedge funds that have pushed investors’ time horizons to crazily short levels. We often say that an investment should be made for at least five years – it seems like many in the markets are investing for five days at the moment. As the market reacts and overreacts to news, there are oppor-tunities for smart managers to pick up bargain stocks at an attractive yield.

This is only the second time in the past 10 years that the Liontrust first income fund has yielded more than government bonds (gilts). The last time was in early 2003 and marked the low point in the UK market. Patient investors in the fund were rewarded with a return of over 80 per cent over the next three years. Now, of course, history does not always repeat itself but in my opinion this is a sign that makes equity income funds seem especially attractive. The truth is that sensible businesses should be able to grow their dividends as fast as inflation, even in difficult economic times.

The point with income funds is to remember that patience is often rewarded. While you are waiting, you can enjoy an excellent yield. Many investors believe that an income fund is only for those who need to enhance their income but that is to forget the concept of total return.

Equity income funds have over the long term tended to beat their more capital growth-orientated peers. The discipline of buying out-of-favour stocks and then selling them once they are in favour works very well over time.

In fact over 100 years, more than two-thirds of the return from the UK stock market has come from dividends. I believe the Liontrust first income fund is one that brokers should re-examine. It is one of those classic investments where patience and a long-term approach will be well rewarded.

Mark Dampier is head of research at Hargreaves Lansdown


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