Search for profitable companies hots up as recovery is expected to be shallow
Neil Woodford, manager of the £2.52bn Invesco Perpetual High Income and £714m Invesco Perpetual Income funds, has adopted a defensive position, seeking out companies able to demonstrate resilience in the face of a sustained period of weak equity markets.
That will be important, Woodford said, in addition to finding companies able to maintain or grow dividend levels, as the anticipated global economic recovery will be anaemic and shallow. Currently, the UK equity markets carry an annual dividend bill of £40bn, compared to the S&P 500 bill of around $40bn, a 42% lower yield from a market four times the size.
He said: 'That demonstrates the high dividend bill carried by the UK markets, which is a huge cash burden. The market is going to refocus on the part dividend plays in total return but dividend paying capacity will be undermined and dividends reduced.'
'In this environment, you have to focus on which companies can sustain the level of distribution or grow it and which cannot.'
The funds, which differ only in that High Income contains a fixed interest element to boost yield, will continue to perform, Woodford said, denying equity income funds have had their day after a rally in value stocks.
Woodford believes the attractiveness of dividend-paying stocks will continue. Not only do so-called growth stocks remain overvalued, he said, though not to the same massive levels as two years ago, but many have been systematically flattering earnings for the better part of 10 years.
'As well as that,' Woodford said: 'We will be struggling over the next 10 years to deliver 7% per annum. When you have got a stock that starts with a 4% yield and is growing its dividend at say 5%, you have already got a 9% return before you see any re-rating of that stock.'
Woodford, who suffered heavy criticism for refusing to play the technology, media and telecommunications bubble, has responded with two years of strong performance.
Over the three years to 13 February, the Income fund is ranked seven out of 79 funds in the IMA UK Equity Income sector, with offer-to-bid returns of 23.2%, compared to a sector average of just 1.9%. The fund's bid-to-bid three-month returns of 10% to the same date rank it first in the sector of 88 funds.
That compares to the three-year sector average of the IMA All Companies Sector, which posted a negative offer-to-bid return of 3.5%.
Woodford, who marries a top-down global and domestic view with bottom-up fundamental stockpicking, said: 'I have concerns about the strength of the economic recovery everyone is looking for. It will come, but it will be very anaemic. We will, at some stage this year, worry about a double dip in the US economy. I am worried about deflation but, on the other hand, the extent of the monetary and fiscal stimulus into the economy will inevitably impact.'
Avoiding a recession in the US by the use of monetary and fiscal policy will have a cost, Woodford believes, which will be manifested in the length and weakness of the recovery.
'At times, it won't look like a recovery at all, rather like the UK recovery in the early 90s as we emerged from recession,' he said. 'We had three or four years of weak growth and rising unemployment. It will be a difficult environment in which to grow profits. The outlook for corporate profits is very, very weak. As a result, given the high valuations companies are on and that we have had 10 years of firms flattering their profits, we are in for a difficult time. I have become more defensive in my strategy and am focusing on cheap shares, which have resilience in the face of a weak market environment.'
Despite the economic, accounting and valuation headwinds that will cause the market to struggle, Woodford said, it will be possible to produce reasonable returns from a well-picked portfolio because there are still plenty of undervalued stocks in this market. 'The market is still hung up on the idea of playing the lottery option,' he added.
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