Over the last few years equity income funds have found it increasingly difficult to keep up with the...
Over the last few years equity income funds have found it increasingly difficult to keep up with the FTSE All Share Index as the market has placed greater emphasis on growth than on value or yield.
This trend has gained momentum recently and, for many companies outside a select group of large technology stocks, it has been a trying period. Trading conditions have been difficult given the strength of sterling and rising interest rates but it is the harsh de-rating of their earnings which has left so many shares trading well below their previous highs.
Supposedly defensive consumer stocks have been particularly hard hit. Boots, Bass, Whitbread and Hilton Group are a few examples of high quality, established companies whose valuations have plummeted to unrealistically low levels that appear to have little regard to fundamental analysis.
The converse of these undervaluations has been the revitalised interest in any stock perceived to have exposure to telecoms, the internet or any area where technology is at the fore. In practice, the scope for equity income funds to hold such investments is rarely high. Stocks such as ARM Holdings, Colt and Energis do not sit happily in such a portfolio.
Undoubtedly income fund managers are feeling increasingly uncomfortable as share prices continue to soar. Many have already been badly scarred by underweight positions in Vodafone. Some must be succumbing to the temptation to reduce the risk by switching out of the underperforming consumer cyclicals - many of which are on P/E ratios of 10-12 and huge yield premiums - and into ARM, say, on a P/E of over 500 and with no yield.
Should they do it? Probably not. It is not that some of these technology stocks do not have growth prospects. They are often substantial but prices that investors are willing to pay for these prospects often rely on overly optimistic revenue projections. They undoubtedly make little allowance for the risk of new entrants who will inevitably be attracted by the expectations of high returns.
A further factor having an enormous effect on the pattern of performance of a typical equity income fund is the pressure on many institutional funds to align their holdings more closely to benchmark indices. The self-fulfilling effect of these moves - as shares rise so does the pressure on them - has accelerated to the point where it must be asked whether passive indices should hold such sway over how funds are invested. In terms of searching for value for our investors, equity income fund managers are increasingly obliged to look away from the companies that are currently dominating the market's attention. Until these relative valuations move more in line, it is likely that the performance of equity income funds will tend to deviate from indices more so than in the past.
Looking ahead there surely must be some relief for equity income managers and investors in the new year. Two main themes are likely to emerge. First, we expect to see a recovery in cyclical and consumer stocks which are now heavily oversold. The catalyst here will probably be that interest rates do not need to rise much further, together with some more confident profit projections. Second, the market will realise that the high prices being paid for growth stocks cannot be justified. The coming months may see some respite for the UK equity income sector.
Richard Prvulovich is fund Manager at Investec Guinness Flight
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