Equity income products have been a mainstay of the funds market in the UK for over 15 years and thei...
Equity income products have been a mainstay of the funds market in the UK for over 15 years and their increasingly compelling investment case has seen a recent surge in interest from investors. In this article, one of the most highly regarded Fund Managers in the industry, Graham Ashby, gives us his views on this asset class.
A compelling case for equity income
• Dividends, an important part of total return...
Dividends remain an important part of the total return offered by shares in the UK, a situation which holds true over any period. This is illustrated by the chart below.
• Attractive absolute income
Although dividend growth had been falling, the valuation correction of the past few years has boosted the yield on equities to the point where it has come close to exceeding the base rate for the first time since the 1960's.
Interestingly, the income from equities now looks competitive with residential property yields, especially in London. For instance, FPD Savills recently quoted the average net yield in Greater London at around 5.5%, whilst in prime central London it is just 3.1% (Source: UK Residential Research Bulletin, July 2002). They also highlighted that even these cash flows could
turn sour should the property take time to let.
• Dividend growth and dividend cover under pressure
Whilst yields have become more attractive, I am concerned about future potential given signs of declining growth in dividends. It is also clear that the current economic environment has put dividend payments under pressure. Whilst
dividend cover from earnings is reducing, a typical firm's ability to make payments out of cash flow paints an even bleaker picture.
• Good stock selection remains vital in volatile markets
Such an environment illustrates the importance of strong company research, and how using detailed cash flow analysis indicates where dividends are sustainable. There are always some businesses that buck the trend by maintaining a strong income for their investors.
In addition, companies are becoming more active in returning cash to shareholders. Canary Wharf is an excellent example of this. I believe it looks attractive on valuation grounds, but also because it intends to make a special dividend to shareholders now that its development plans are close to completion. This will provide the Fund with a useful income stream that can be
paid out to unit holders.
A careful balance between
My primary objective as Fund Manager of the DWS UKEquity Income Fund, is to out-perform the FTSE All-Share Index over the longer term through a combination of capital growth and income. At DWS Investments our process is pragmatic and stock driven. Given the increased volatility within the UK stock market in recent years, I believe it is important for this core Fund to have a balanced approach to portfolio construction rather than solely picking stocks from a narrow high yield
universe. In my view, this balanced approach is increasingly relevant in an environment where fewer companies are growing their dividend and dividend cover is falling. Having said this, to qualify for my sector I need to generate 110% of the yield on the FTSE All Share Index.
This search for quality companies which also offer attractive yields can mean that the Fund has a slight emphasis on medium-sized firms relative to the largest in the Index. I do not benchmark myself directly against peers in my sector, but my style has generally been positive for fund performance, relative to both the index and my peer group.
Our UK team is among the strongest around, therefore I seek to maintain a reasonable level of commonality with the UK model portfolio to ensure investors benefit from our best ideas. I also include a number of my own selections, given that the latitude for individual flair remains an important element of our active management proposition. The ideas of individual fund managers are debated with peers, which adds some healthy 'creative tension' into the decision making process.
The trouble with earnings
This year has played to the strengths of our cash flow based approach to analysing companies, as it has highlighted the dangers of taking reported earnings at face value. Accounting practices vary dramatically from firm to firm, even within
the same industry sector. A recent comparison highlighted the differences in accounting practices used for R&D spending by car manufacturers. Some companies smoothed their reported profits by capitalising some of the costs, whilst others suffered greater volatility of earnings by writing off spending on R&D in the year incurred. This illustrates that earnings based comparisons between companies can be highly misleading. Our detailed analysis of the cash flow statement strips out the effect of different accounting policies, providing us with an invaluable assessment of the quality of reported profits.
Investment strategy in 2002
I started the year cautiously, emphasising defensive shares, primarily through the tobacco and water sectors, where valuations and yields looked attractive. In the tobacco sector I like ImperialTobacco because it represents a highly
cash generative business with a strong stable of brands. It also has minimal exposure to US litigation. Holdings among water companies out-performed, taking valuations close to their regulated asset base. I became increasingly concerned about the sustainability of dividends post the next regulatory review, as many companies are heavily indebted and have significant investment plans. As a result, I took profits and used the proceeds to increase holdings in economically-sensitive areas, such
as building materials.
For the purposes of generating a suitable level of income, I have concentrated on investing in companies which generate sufficient cash to at least maintain their current level of dividends. My holding in Tate & Lyle was recently increased
as management had disposed of under-performing assets, leading to an improving trend in both returns and cash generation, a fact which I do not believe is fully recognised by the stock market. I also like Hilton at current depressed levels, partly because the shares offer a yield of 5.5%, but also because the market does not appear to recognise that the significant
improvement in profitability at Ladbrokes should help offset the downturn in trading in hotels.The Fund remains lightly represented in highly valued large consumer concentrated companies (such as Tesco and Diageo) where I believe that
expectations for growth look too high. In terms of areas that have hurt performance this year, my overweight position in
pharmaceuticals (through AstraZeneca) has proved negative. Valuations have been under pressure due to delays in the launch of new products, poor clinical trial data and challenges to important cash generative drug patents.
Uncertainty dominates, but buy signals are emerging
The threat of war on Iraq caused the oil price to rise and heightened fears of a 'double dip' recession, whilst corporate governance concerns continue to weigh on the market.
• Positive signals of value
However, on balance, I remain convinced that a gradual economic recovery is the most likely outcome, despite the current poor state of economic and corporate earnings news flow.
This should be positive for the UK stock market, particularly given that recent uncertainty has driven shares to attractive levels relative to bonds, cash and even property hot spots.
The director buy to sell ratio is also providing a particularly encouraging signal, illustrating that management are confident that analyst expectations for earnings are realistic and achievable.
• Shares an attractive long-term investment
Experts say that longer-term, total returns are likely to be lower than we have seen over much of the past 20 years, however, we believe that equities are still more likely to out-perform all other asset classes.
• Balanced style differentiates the Fund and is appropriate given pressure on dividends
• UK equities look cheap compared with bonds, cash and even some residential property
• Directors are buying shares which increases our confidence in earnings estimates
• Cash flow based analysis provides an invaluable assessment of the quality of earnings
The opinions are those of Graham Ashby, Fund Manager of the DWS UK Equity Income Fund as at 18/10/02 and may not reflect those of our Group. Please remember that past performance is not necessarily a guide to future returns. The price of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Current tax levels and relief's will depend on your circumstances and may change. Charges are taken from capital. Whilst this enhances the income yield, it may reduce the potential for
capital growth. For more information about the risks associated with this Fund, please refer to the Key Features Document. Issued by DWS Investment Funds Limited, One Appold Street, London EC2A 2UT. Regulated by the FSA.
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