With a running yield close to that of the typical building society account and the possibility of some useful capital gains, higher yielding equities could be the answer for investors looking for income this year
The UK stock market again delivered a negative return in 2001 and the US economy continues to struggle with recessionary conditions. As we enter 2002, interest rates continue to fall on a global basis, bond yields are near historic lows and finding income is ever more difficult for savers and investors alike. So, against this background, will 2002 be a good year for income shares?
The answer may be to look at higher-yielding equities, an investment that provides a running yield not far short of the typical building society account, in addition to some useful capital gains as and when equity investment returns to favour. However, before considering prospects for income shares in 2002, let us look briefly at their performance in 2001.
The best proxy for equity income shares within the UK stock market is the FTSE 350 High Yield Index, essentially the higher-yielding half of the stock market excluding smaller companies. Over the calendar year 2001, the FTSE 350 High Yield Index outperformed the FTSE All-Share by just less than 10%. In other words, higher yielding shares outperformed the broader stock market by a large margin.
Is this outperformance typical or is 2001 an unusual year? The FTSE 350 High Yield Index has been calculated since 1986 and, since then, has consistently outperformed the stock market as a whole, with the exception of the technology bubble at the end of 1999.
Why have income shares done so well? Part of the answer can be explained by looking at where income is derived from in the stock market income is derived. During the calendar year 2000, 19% of the dividend income the stock market generated is estimated to have come from banks, 13% from integrated oil companies, 8% from pharmaceuticals and only 7% from telecommunication stocks.
When thinking about prospects for 2002, it is important to keep in mind that two key sectors account for nearly one-third of all dividend income in the UK. It is also worth noting that telecom shares have been a consistently modest source of income within the stock market, despite the overall importance of the sector in terms of market capitalisation.
What do the prospects look like for 2002? The US terrorist attacks in September had a profound impact on financial markets across the world. Most commentators are now in agreement and expect US consumer confidence to collapse and, consequently, the US economy to go into recession. The issue is now the length and depth of any recession. This very difficult economic environment will clearly have a major impact on the UK, with the likelihood of further poor corporate newsflow over the coming months.
At Axa Investment Managers, we believe interest rates and fiscal policy will engender a quick bounce back in the global economy, with inflation targets taking a back seat, at least temporarily. Re-establishing economic growth will be more important to the authorities than inflation risks. Any cyclical pick-up in inflation can be dealt with at a later date.
We are positive on economic prospects for 2002 as a whole and expect the broader stock market to respond positively to our economic scenario over the course of the year. This view clearly has risks ' who would have forecast 11 September, for example ' but despite this the sort of events we saw in the US have historically tended to be good longer-term buying opportunities for equities. Overall, we believe investing in equities, tilted marginally towards economically sensitive stocks but focused on those that are financially strong, is the correct investment decision in 2002.
Against this background, how attractive do income shares look? Looking initially at the bank sector, the most important source of income within the UK stock market, some interesting investment opportunities exist. Two examples are HSBC and building societies in general. HSBC offers a secure and growing yield of more than 4%, is financially strong and will benefit from economic recovery as and when it occurs. Building societies, such as Bradford and Bingley, offer an equally attractive growing yield.
Bradford and Bingley's shares yield more than typical building society savings accounts, which has been a catalyst for good share price performance such as in March 2000 at the height of the technology bubble. Elsewhere, we can find tremendous opportunities in certain economically sensitive mid-cap stocks, which are currently being overlooked by the market.
However, selectivity will be key. Some companies have become far too sanguine about high debt levels following the long period of sustained economic growth, which will be an issue for 2002, especially as the economy starts to pick up.
Looking back to the early 1990s, a number of companies went bust while apparently being very profitable. Cashflow was the key in this era, or lack of it in the case of the companies that went bust. Strong balance sheets, good cashflow characteristics and low rating will be the main factors in identifying the winners in 2002 and a number of high-yielding shares offer exactly these characteristics. Michael Page, Premier Farnell and Taylor Woodrow are a few examples of stocks that currently fit this definition of good value. P&O Princess fitted this category a few months ago, before it was bid for. Watch out for more corporate activity this year as the economy starts to pick up.
Looking forward, if inflation expectations pick up ' they are currently very low if one looks at the inflation levels implied by current bond yields ' then long-duration stocks will be disproportionately hit. This background would be favourable for income shares. Given the current fiscal and monetary policy of most major economies, bond yields are more likely to rise than fall during 2002, providing, once again, a positive environment for shorter-duration stocks.
The past couple of years have been challenging for income fund managers, with investor interest in the early part of 2000 generally focused on technology stocks and few people interested in so-called old economy stocks, which some commentators dubbed, rather unfairly, as legacy companies. The technology bubble is now well and truly deflated but it would be a brave investor who wrote off the new economy. Technology is here to stay and there will be tremendous opportunities, as well as huge disappointments.
Many old economy companies are well managed and have successfully embraced technological change, just as many technology stocks currently appear to be tremendously well placed but will ultimately fail.
Investing invariably comes down to backing good management teams, timing and valuations. It is no coincidence that well-managed companies tend to have strong market positions and excellent cashflow characteristics. Markets tend to come back to fundamentals in the end. Technical stock shortages only drive up shares when fundamentals are strong.
As an income fund manager, it is interesting to me that as a patient investor, one can often buy quality companies on a yield premium when they are out of fashion for some reason connected with short-term stock market sentiment. Whoever said the stock market was totally efficient.
At the start of a new year and with recession just starting to bite, perhaps UK equity income funds may be due a bit of a renaissance.
Against a background of low interest rates, finding income is harder than ever.
Two key sectors account for nearly a third of all dividend income in the UK.
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