the peer group has tended to avoid the worst excesses of the growth bubble but some have been caught out by the recent split cap debacle
Funds in the UK Equity Income sector have proven more robust in preserving capital than their UK All Companies counterparts after avoiding much of the de-rating of growth.
Although all 84 funds in the income sector with one-year track records posted negative growth over the 12 months to the end of August, over three years performance is more divergent.
While the difference in three- year performance between the top and bottom funds in the sector is in excess of 115%, this is largely down to a number of funds investing for income in the now failed split cap investment trust sector.
Martin Cholwill, fund manager of Axa UK Equity Income since 1996, has been able to steer a path to consistent returns.
The fund has outperformed the sector average in each of the last three discrete 12-month periods, returning -4.3% over the full three year term, bid to bid, versus a sector average of -11.62%.
Cholwill said the bulk of the outperformance can be attributed to his running a diversified portfolio driven by bottom-up stock selection. The core of this process, which has led to outperformance in both bull and bear markets, is centred on cashflow analysis.
'I have always been a believer in looking at the cashflow of companies. Profits can be misleading and are certainly more subjective. With cashflow you can see whether the cash is in the bank at the end of the year and it strips the effect of non-cash items out of profits,' Cholwill said.
'The key is identifying companies on yield premiums with a growing dividend backed by sustainable cashflow. I avoid high-yielding stocks where the dividend cannot be maintained.'
Company meetings play a key part in the stock selection process too, with Cholwill able to benefit from Axa's size, which facilitates getting company management in to chew the fat.
Cholwill said this strategy often leans him toward quality but out of favour stocks, such as British Energy and British Airways in the mid-90s. Small-cap exposure is minimal, usually below 5%, due to the size of the fund, which is currently at some £600m, he added.
He also tends to avoid following themes or strong sector biases and stressed that the fund is more characterised by numerous holdings providing smaller contributions to performance rather than the barbell strategy favoured by some of Cholwill's peers.
This did limit the upside between September 1999 and the end of August 2000, with the fund posting growth of 6.45% versus a 6.4% sector average.
Although the fund still outperformed, it was down on a number of its peers who dipped their toes in growth stocks. ABN Amro UK Equity Income, for example, delivered a 53.53% return over the same period, despite being run with a below average risk profile as judged by its beta score.
Cholwill said: 'I tend to have the majority of the risk in the portfolio stock specific rather than in sectors and themes. I have about 65 stocks and just try and aim to take enough risk to achieve consistent top quartile performance.'
The fund did have a couple of technology companies, one of which, Spirent, Cholwill sold out of for a profit in late 2000.
This along with strong weightings in more defensive areas of the market enabled the fund to beat the sector average over the course of September 2000 through to August 2001.
Over this period, Axa UK Equity Income posted positive growth of 1.37% versus an average loss of 2.55%.
The fund's one-year return was again in excess of the sector average, -11.32% versus a sector average of -15.31%. Cholwill said although defensively positioned, such has been the market there have been few safe havens.
Bill Mott, manager of Credit Suisse's Income and Monthly Income funds, has also been defensively positioned over the last couple of years.
Mott said the funds' turnover was low last year compared to previous years as he maintained overweights in defensive sectors such as housebuilders and food producers.
This helped the funds preserve capital better than their peers to the tune of 9%. Income is down 6.69% and Monthly Income down 6.74% over the 12 months to the end of August, versus the -15.31% sector average return.
This outperformance also helped keep Monthly Income the sector's top-performing fund over three years, up 29.12% over that time, versus a -11.62% sector average. Income is the third best performer over the same period, up 28.71%.
Mott is well known for his pragmatic approach to investing. As a self-confessed thematic investor, he places great emphasis on top down analysis, a major factor in his avoidance technology at the height of the boom.
Despite evidence to the contrary, Mott plays down his stockpicking skills as a secondary discipline, although he does tend to focus on quality companies with attractive, yet sustainable yields, backed by strong cashflow.
He said: 'Some people may say I am a value fund manager who has managed to capture the revaluation of value stocks, but I think that is unfair.
'I am a thematic investor and throughout my career I have been more of a growth than a value investor anyway.
'In a market that is trading sideways though, it is all about being cautious and investing in companies with predictable earnings, which is why UK equity income will outperform any other UK asset class this year.'
The funds' strong outperformance between September 2000 and August 2001, was largely due to the aforementioned heavy underweighting of technology, media and telecoms throughout 1999. While this drew criticism at the time, he was of course soon redeemed as growth succumbed to a major de-rating.
His sectoral positioning also led to subsequent returns of 17.97% for Income and 18.17% for Monthly Income between September 2000 and August 2001.
Looking forward, while bullish on the UK equity income sector, Mott said the economic environment will make growing corporate profits difficult as the consumer is forced to slow his spending to service debt and inflation remains low.
Mott noted: 'Equities are too expensive on an earnings basis, so companies with relatively modest earnings growth paying good dividends will provide good total returns versus cash and bonds, but will also be re-rated.
'Companies are becoming valued much more on their cash return to investors and are becoming increasingly aware of this, and that is why I think equity income funds are going to continue to do well.'
Paul Bruns and Elaine Parkes
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