With the recent changes to advance corporation tax (ACT) and the consequent withdrawal of tax credit...
With the recent changes to advance corporation tax (ACT) and the consequent withdrawal of tax credits from equity income funds, many commentators now see bond funds as the income vehicle and equity funds as the growth vehicle.
This attitude is, however, quite concerning. Equity income funds have proved to be one of the most popular and enduring sectors of the UK unit trust industry and to write them off so quickly could distract investors away from a core investment product at a time when they may need it most.
Before considering the central case for equity income funds it is appropriate to first decide whether UK equities themselves offer any value at the moment. What has been happening in the UK and global economy and how does that affect the outlook.
During the second half of 1998 most commentators were considering the global economic problems that had been caused by the collapse in a number of emerging markets, particularly Asia. As a result of this uncertainty most global stock markets, including the UK, experienced high volatility. The main fear was of global recession from which no country would be immune.
Since then interest rates in many countries have been cut. The Bank of England cut its base rate to 5% which helped to avoid full recession and as a result the economy is now strong. There has been a rebound in the UK stock market and expectations of growth are rising.
The ongoing debate now is how far interest rates can be cut without creating inflationary pressure and another boom in the UK economy. At the moment there is little evidence of inflation either in wages, consumer prices or commodities and the only risk appears to be the return of strength in house prices which are rising quickly in the South East in particular.
The Bank of England's objective is to keep inflation within the parameters set by the Government and it is possible that it could well fall into the bottom of the range. This leaves the door open for another rate cut but with GDP estimates for next year already at 2.5% this may push the economy along too quickly. It is therefore more likely that we will have to become used to regular movements in interest rates, the fine tuning instruments for the economy, and we could possibly see them rise again either late this or early next year.
Stock market shifts
These events have led to a significant change in the stock market. For almost two years the market had been driven by a small number of large companies that are perceived as growth plays. Now there is some clarity being given as to the direction of the economy, investors began looking at sectors which had been more sensitive to economic conditions the cyclical stocks.
These sectors have been performing relatively poorly, but appear cheap against the rest of the market and, with improving market conditions, their earnings and dividend prospects have much improved. Cyclical companies have greater representation in the small- and mid-cap sectors and the move away from investing predominantly in larger companies has been significant.
With this broadening of the market and a positive economic outlook UK equities appear to be good value with yields on the small- and mid-cap companies looking particularly attractive especially when compared with gilts. While a lingering concern remains over the potential for further tightening in US interest rates the management of the UK economy has been good and is expected to continue in the same vein.
Another major development in 1999 was the creation of the euro. At the time of its launch on 1 January it was broadly expected to be one of the stronger currencies, but weak growth in France and Germany and a perceived lack of action by the European Central Bank, along with some political problems, have conspired to see it remain rather weak since inception. However it has enjoyed some strengthening lately due, in part, to the pick up in Germany's GDP growth.
The weak euro has ensured the continuing strength of the sterling despite a backdrop of falling interest rates. As a result the UK manufacturing has suffered from being less competitive. This sector now accounts for just 18% of the total market and is set to fall further over the coming years.
In these conditions investors should be looking for quality active management, with expertise especially important across the small- and mid-cap sectors. Clearly equity funds having a role to play.
According to S&P Micropal, equity income funds have, on average, outperformed the average corporate bond, gilt and all company (equity growth) funds over each of five, 10, 15 and 20 years. This proves the equity income fund is not only a bellwether product at times of economic uncertainty but is also capable of capturing the upside when markets move ahead
Is this just a function of the reinvestment of the dividend income or is it a function of the type of company that an equity income fund looks to invests in? It is most likely to be both.
To ensure an equity income fund receives dividends from its investments, and it grows this dividend stream each year, a strict discipline must be applied. The key is to analyse carefully both the dividend history and the potential of a company, preferably over an entire economic cycle.
The dividend is a function of the profits and earnings growth of a company combined with its cash generation. The ability to grow profits and generate cash over the long term, throughout the full economic cycle, is the prime factor income fund managers look for, as this will result in dividend growth. It is only good quality companies that can do this. Those with 'must have' products operating in growth markets that are in control of their own destiny and are run by good management. Not surprisingly, these companies also perform well in terms of share price.
Strong balance sheets.
Some people have been scared off equity income funds following the changes to
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