The UK equity income sector has been fertile ground for investors over many years but the damage d...
The UK equity income sector has been fertile ground for investors over many years but the damage done by the bear market has put many funds in the sector on a defensive footing, with some becoming virtual equity and bond income portfolios.
The recent rally has seen such funds move from the top of the short-term performance table to the bottom, replaced by funds from the basement. What will it take for the improved performance of the new leaders to continue?
It looks increasingly likely that UK stocks bottomed on 12 March and are now in a bull market. As usual, the lead came from the US, where lower taxes, interest rates, oil prices and a lower dollar bolstered consumer, business and investor confidence. This caused the S&P 500 to break out of its three-year downtrend and head north, a technical breakout confirmed by both volume and breadth.
This is not to suggest equities will continue to go up in a straight line. Indeed, after a 25% rise in just three months, some sort of setback is almost inevitable. However, it does mean downside should be limited and investors can once again think in terms of making money from stocks rather than limiting losses.
If the above summary is correct, there are major ramifications for UK equity income funds. In a nutshell, managers of such funds will need to be more aggressive, or they could lose out on both the capital and income front.
Dividend yields are in many cases higher than deposit rates and dividend growth should re-emerge as corporate earnings improve and the bull market progresses.
This means reducing exposure to gilts and investment grade bonds, where returns are distinctly dull and the fixed interest bubble may be about to burst. At the same time, it means increasing exposure to equities, including higher risk, high-yield equities.
I would suggest a two-pronged strategy. The main area for investment should be top quality, blue chips, mostly FTSE 100 stocks with a smattering of mid caps ' stocks like Legal & General yielding 6.2%, Gallaher offering 4.7% and a host of household names like HSBC, BP, BT and Marks & Spencer with prospective yields approaching 4%. There is simply no need to buy illiquid second liners with a much higher risk of dividend cuts.
I believe there is merit in spicing up the income account with a look at the split-capital investment company sector, in particular income and residual capital shares. After a torrent of selling in the wake of the much-publicised splits crisis, the baby has been thrown out with the bathwater, creating real value at the quality end of the spectrum.
I would recommend stocks like Edinburgh Income and Value, a modestly geared stock with a well covered zero that yields 11.1% and returns 12% (net redemption yield) even with no growth, and Jupiter Enhanced Income, a short life stock with no bank debt that yields 15.8% and returns 22% with no growth.
Needless to say, if you don't believe we are in a bull market, don't do any of the above.
Investor confidence on the rise.
Many household names yield more than 4%.
Bargains on offer in income shares of splits.
Irish border, resignations, market volatility and more
Revealed – successes across all 11 categories
Fidelity International multi-asset CIO James Bateman talks to Julian Marr about recent market volatility, portfolio positioning and his thoughts on the coming year
Follows Phil Young
‘Positive so far’