The search for income

Value and growth are often viewed as two sides of the same coin. If your portfolio is 50 per cent in value-oriented investments, it is fair to suggest the other 50 per cent is in growth – or, as they tend to have it in the US, ‘momentum’ – stocks.

If you are 30 per cent in value, then the chances are you are 70 per cent in growth.

If you ask them nicely, the analysts at Morningstar can break down portfolios by investment style and so we asked them to do just that for funds in the UK Income category.

We then made the reasonable assumption that, if a fund has more than 50 per cent in value-oriented stocks, it has a value focus and, if it has more than 50 per cent in growth stocks, it has a growth focus.

The funds that make up Morningstar’s UK Income sector boast a chunky £87bn in assets under management.

We disaggregated this figure into the percentage value run by each investment house and then ranked everything according to the degree to which they are focused towards value or growth.

The resulting chart (right) paints an arresting picture.

As you can see, 87 per cent of all £87bn of funds under management in the UK Income sector have a greater than 50 per cent bias to growth, which of course means just 13 per cent have any sort of tilt towards value.

Prominent in the former camp is the vertical line towards the right of the chart, which represents the £18bn one investment house has across its stable of growth-oriented income portfolios.

Towards the left of the chart, the great majority of the £5bn or so of assets with a 60 per cent or higher tilt towards value are also run by a single investment house.

We presume its identity goes without saying and so will instead concentrate on what this chart is saying – most obviously that, as things stand, almost nobody wants to touch value.

That is because value pretty much embodies everything investors currently find problematic – commodities, banks, volatility and so on.

In contrast, growth is a much easier decision for investors – at least at first glance – and there is certainly no denying a lot of the funds that make up the right-hand side of our chart can point to excellent 10-year track records.

Yet we know markets are cyclical over time. We know businesses and sectors – whether they have been doing well or poorly – revert to the mean over time. And we know that – again, over time – value has a long, long history of outperforming growth.

All of which means the funds on the right-hand side of the chart – and their investors – represent a strong bet against history repeating itself. Over time.

The chart also has us wondering about the way many investors will say they like to diversify their income exposure by blending together different funds with different holdings.

Well, of course that is possible but investors taking this approach with UK equity income funds might want to revisit just how diversified they currently are.

Certainly, if you were to pick two funds at random from the UK Income sector today, with a view to blending them together, the odds strongly suggest you would end up with two portfolios of very similar stocks and not a great deal of genuine diversification. You would only achieve that by blending two funds with different investment styles.

As keen commentators of behavioural finance it does not come as much of a surprise to see such a huge bias to the investment style that has performed so well over the last decade or so.

Of more interest to us, however, is the huge risk we believe this positioning now poses to the great majority of investors in the sector – and the great opportunity it presents to our own investors.

Nick Kirrage is fund manager, equity value, for Schroders.

Countless people across the UK depend on reliable income streams from their investments to fund everything from retirement to holidays.

Yet ever since the Bank of England (BoE) decided the best way to fix a dormant economy is to encourage households to spend more, opportunities to earn a salary from investments have become much harder to come by.

Cash and bonds don’t cut it anymore
Saving accounts were one of the biggest victims of the BoE’s latest package of Keynesian-inspired measures. When policymakers slashed interest rates by 25 basis points to an all-time low of 0.25 per cent, returns on 354 saving accounts were cut by the same margin or more within the same month.

According to Moneyfacts, the average easy access account generates just 0.49 per cent. As inflation currently stands at 0.6 per cent, and is expected to rise to 2 per cent by early 2017, those still hoping to generate an income in this way are now losing money.

Gilts, which are often seen as the second port of call for risk-averse income investors, don’t fare much better, either. The interest paid on lending money to the government over 10 years has been languishing at record lows ever since results from the Brexit referendum sparked a rush to safe haven assets.

Now that the BoE has reintroduced its multi-billion-pound bond-buying programme, the gap between prices and yields is set to widen even further.

Given this situation, and the knock-on effect it is having on other assets in the fixed income market, Tom Becket, chief investment officer at Psigma, no longer feels comfortable recommending government or corporate bonds to clients.

“Let’s assume that all investment managers charge their clients 1 per cent, and that the average annual inflation rate will be 2 per cent over the next ten years,” he says.

“The ‘real’ or inflation-adjusted return of the UK ten-year gilt will be -2.35 per cent annualised. It is hard to recommend that to a client and, worryingly, we are fast approaching the point where it is not just government bonds offering such miserable outcomes, but also huge swathes of the corporate credit universe, too.”

Equities calling
With cash and bond returns at all-time lows and another popular alternative, property, attracting high costs and unfavourable tax treatment, the options available to income investors are narrowing.

Judging by recent data, which shows record inflows into stocks and shares Isas over the past tax year, many now accept that the riskier equity market is the only hope left.

Low interest rates are generally good for companies, as they enable them to borrow for less. By pushing down the value of the pound they have also provided a timely boost to blue-chip groups, many of which generate most of their revenues abroad. Income investors will be particularly pleased, given that plenty of these names happen to be among the biggest dividend payers.

Inexperienced investors keen to capitalise on these trends will probably prefer to buy into a fund, rather than purchase individual shares, as they generally provide greater diversification and a hands-on approach from experts in the field. But with such a vast array of attractive options on the market, finding the most suitable ones is no easy feat.

Back managers with solid track records
According to Laith Khalaf, ‎senior analyst at Hargreaves Lansdown, a good starting point is to identify funds run by successful managers. “It’s best to back managers with a long-term track record of delivering robust total returns, and fortunately the equity income sector is blessed with some real investment talent,” he says.

“The big name in the sector is of course Neil Woodford, who runs Woodford Equity Income. But, likewise, there are other seasoned campaigners in the UK equity income universe with a history of outperformance.”

For example, the £667m Schroder UK Alpha Income Fund, managed by Matt Hudson, has a historic yield of 4.45 per cent, with holdings in high dividend-paying value stocks such as British American Tobacco, Royal Dutch Shell and BP.

Don’t chase yield
Another important consideration to make is how much yield you require to maintain a decent standard of living. Some funds offer mouthwatering dividends in the region of 7 per cent, although most, including Mr Khalaf, agree that something between 3.5 per cent and 4 per cent is a more realistic starting point.

In some cases, high yields can represent heavy price falls within portfolios, or an accumulation of stocks that pay out more than they can realistically afford to shareholders.

“Where income investors can go wrong is by starting with a certain yield requirement and letting that drive their share selection process,” says Todd Wenning, research analyst at Johnson Investment Counsel.

“If your yield requirement is far above the market average yield, you might end up building a portfolio of riskier securities than you'd have liked. You might enjoy a few quarters of high income, but you also run a higher risk of dividend cuts, which could impair your longer-term income potential.”

Dividend cuts rock the UK
UK investors have grown accustomed to companies slashing payouts. According to research by Share Centre, many of the nation’s biggest names spend more on dividends than they make in profits.

That worrying admission helps to explain why second quarter underlying dividends in the UK were the weakest performer among the Group of Seven leading industrialised nations.

Mr Khalaf reckons that axing dividends is “part and parcel of income investing” – and that free cash flow cover has now largely been restored, following a spate of high-profile cuts across big British companies.

But others worry that a continuation of poor earnings growth, particularly within the usually high-yielding banking, oil and mining sectors, could trigger more devastation. Rising pension obligations have added fuel to this argument.

Pension funds mainly use government bonds to discount the value of their liabilities. While that was previously sufficient, today’s environment of sinking yields has lifted combined deficits of the UK’s 6,000 private sector defined benefit schemes to a record £1trn.

This predicament recently saw small-cap plastics manufacturer Carclo slash its dividend and analysts ponder which leading companies will be next.

Concerns over the ability of UK companies to finance dividends has clearly been bothering Neil Woodford. Since its launch in 2014, his popular equity income fund has nearly halved its FTSE 100 holdings to nine. Recent casualties include Royal Mail, BT and defence group BAE Systems.

Fortunately, those who share Mr Woodford’s anxieties have the option to explore other regions. The equity income sector is a vast space offering investors the opportunity to focus on specific areas of the world, or take a more global approach to investing.

Going for growth in the US
The global prominence of North American companies often makes investing across the pond a popular strategy. As the manager of Neptune’s US Income fund, James Hackman clearly has a vested interest in talking up the country’s prospects.

But he also makes some interesting points about the portion of earnings paid out as dividends in a market that, in his view, is often overlooked.

“Dividends in the US have grown [at] more than [a] 7.5 per cent compound annual growth rate (CAGR) since 1999, versus just 3.5 per cent CAGR in the UK,” he says. “While Brexit fears and commodity volatility has hit the UK dividend market, the US income market is in robust health – and growing.

"With a dividend cover of 1.78 and a payout ratio of just 56 per cent, versus 0.72 and 138 per cent in the UK, the US income opportunities for an active manager are significant.”

Also working in the North American market’s favour is its wide variety of choice. Whereas in many countries decent dividends are restricted to certain sectors, such as utilities and telecoms, Mr Hackman notes that 49 per cent of the S&P 500’s constituents yield in excess of 2 per cent.

According to Diane Sobin, head of US equities at Threadneedle, this diversity is enabling investors to find new opportunities in a market where traditional income stocks have soared in value.

As cash-rich, defensive utility companies now cost an arm and a leg, she’s been busy buying up stakes in lower-yielding stocks with growth potential from other sectors.

“At 31 March the highest-yielding stocks in the S&P 500 were trading at 16.4 times forward earnings, a premium of more than four multiple points relative to their average of the past 30 years,” she says. “By contrast the highest dividend-growing stocks were trading at less than a one multiple point premium.”

Eastern promise
Steep valuations across the developed world has led some fund managers to head east. While markets there may be more volatile, many agree that Asia’s emerging middle class and growing dividend-paying culture has plenty to offer income investors.

Of all the countries in this region, Japan is perhaps the hottest topic. Although its companies tend to yield less than their Western counterparts, there are reasons to believe that the corporate Japanese habit of sitting on cash is beginning to change.

Valuations are comparatively cheap, too, as the Bank of Japan’s poorly received negative interest rate policy sent sentiment crashing.

These developments have captured the attention of Ben Lofthouse, co-manager of Henderson’s Global Equity Income fund. “The payout ratio… [in Japan] is low versus other markets at around 30 per cent, whereas somewhere like the UK would be around 50 to 60 per cent, so there is the potential for dividend growth,” he says.

“We have seen a lot of dividend growth in the last few years from the market as a whole. But it is hard to determine whether it is a cultural change, a change in the way companies are run, or whether it’s more because of the currency gains they’ve made with the devaluation of the yen a few years ago.”

Europe slips under the radar
Mr Lofthouse has also taken an interest in European stocks. Banks generate less profit when interest rates are low, as disgruntled savers place their money elsewhere and lending becomes less lucrative.

However, Mr Lofthouse claims that depressed European share prices fail to reflect that some of these high-yielding names are capable of weathering the storm better than others.

Other attractively yielding sectors that he currently considers to be “very cheap” on the continent include telecommunications, pharmaceuticals and real estate.

VCTS and infrastructure
As the comments above indicate, fund managers are having to adopt new, slightly riskier strategies to find value in the equity income market.

Prices have surged after record low interest rates pushed an increasing number of yield-hunting investors into reliable income-paying shares.

Mindful of these challenges, Jason Hollands, managing director at Tilney Bestinvest, reckons those hunting for yield should perhaps widen their search to include less mainstream asset classes such as Venture Capital Trusts (VCTs).

These actively managed funds invest in small companies requiring money to develop their businesses. As part of their financing often comes from loans, VCTs can also generate impressive tax-free dividends on the side.

Alternatively, Mr Hollands suggests that investing in renewable energy infrastructure might be worth a punt. These vehicles mainly specialise in wind or solar power and, encouragingly, generate a portion of their returns from government subsidies.

“Infrastructure can also be appealing for income seekers, especially as underlying contracts on projects are very long-term in nature and often include annual inflation adjustments,” he says.

“However, core investment companies which own operational infrastructure projects are across the board standing on very high premiums to net asset value (NAV). There are, however, some opportunities in the renewable energy infrastructure space. For example, Bluefield Solar Income is trading just above NAV and is yielding 7 per cent.”

Don't put all your eggs into one basket
If placing all your hard-earned money into the fate of one or two asset classes makes your stomach churn, a multi-asset income fund may represent your best option.

That’s certainly the view of Patrick Connolly, certified financial planner at Chase de Vere, who adds that today’s “volatile and uncertain world” has made it “really difficult” for investors to keep faith with any particular asset class.

“Stock markets have performed very strongly, with many stock valuations now being difficult to justify without increased company earnings,” he says.

“Many fixed interest assets look expensive and could be susceptible to significant falls in the future. And the issues with property investments have been well documented following the EU referendum vote.

“The best approach is to invest in a range of different income-producing asset classes, such as equities, fixed interest and property, to spread risks.”

Daniel Liberto is a freelance financial journalist