The audience angle

Written by Citywire

June, 2020

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The audience angle: 10 things to look for in a UK equity income fund

UK equities remain important for income seekers, but which strategies are fund selectors favouring to weather the dividend drought? Citywire canvassed opinion.

Despite widespread dividend cuts, wealth managers and advisers see attractions in UK equities for income.

‘Even allowing for conservative cuts to dividends for this year – as much as 50% – UK equities still strike us a good place to get income due to their higher yields relative to other equity markets and established culture of returning cash to shareholders,’ said Rory Mcpherson, head of investment strategy at Punter Southall Wealth.

In a world where pay-outs are plummeting, fund selection is more important. Which characteristics should you look for?

1. ACTIVE MANAGEMENT

More than 40 FTSE 100 companies have reduced their dividend this year and James Burns, co-manager of Smith and Williamson’s managed portfolio service, believes ‘now is the time for active management to flex its muscles’.

‘An active approach to selecting those stocks best suited to thrive in the coming years will hopefully prove successful and, dare I say, reap dividends,’ he said.

At a time when communication channels are being revolutionised, he favours managers who are adept at conveying their message and explaining what has – and has not – worked for them. ‘This will give investors comfort in sticking with active management through these tough times.’

2. FLEXIBILITY

Punter Southall uses managers with the flexibility to invest across sector, style and market capitalisation. Historically, half of FTSE 100 income has come from the 10 largest stocks. Many of them are exposed to areas of the market that are cyclical and have made dividend cuts – big banks, for example.

‘Granted, we want an income, but we want that income to grow and not be reliant on the fate of a small number of stocks,’ said Mcpherson. ‘Managers who can generate income from a variety of earnings streams should be more secure.’

3. SMALLER COMPANIES EXPOSURE

Brooks Macdonald is looking for equity income funds with exposure to smaller companies and AIM-listed stocks, where dividends rose in 2018 and 2019 on the back of strong and growing earnings.

‘While the risk might go up, the expectation for a growing dividend with rising earnings does as well,’ said Jonathan Webster-Smith, its head of multi-asset. ‘It is a trade-off in terms of risk and income that we need to consider for this year, with an unconstrained approach perhaps offering investors the greatest opportunity. Flexibility and cash flows are more important than ever.’

4. EXPSOURE TO DIGITISATION

Falkirk-based Tom Munro Financial Solutions favours income funds with exposure to digitisation – a ‘definite force that is impacting consumer behaviour’ across sectors – from financial services and retail to healthcare and property.

‘Amid the uncertainties created by the outbreak, some key themes have come to the fore – the digital trend is fast-tracking at pace,’ said founder Tom Munro. ‘Companies that have embraced the digital transition can still earn attractive revenues and are likely to see their competitive positions enhanced in the current climate. Businesses whose products and services enable this technological shift are likely to become even more valuable portfolio inclusions.’

5. ABILITY TO HOLD LOW OR NON-YIELDERS

Exeter-based Cathedral Financial Management favour managers who are not bound by minimum income requirements when selecting stocks. ‘These managers are able to find stock ideas which are less correlated and in many cases have higher levels of dividend cover than more commonly known counterparts’, said head of investment Shane Bennett.

Canaccord Genuity Wealth Management blends funds focused on dividend growth, like Evenlode Income, with higher-yielding funds like Threadneedle UK Equity Income. Funds like JPM UK Equity Income offer a one-stop-shop to achieving this mix.

6. FOCUS ON BALANCE SHEETS

Casterbridge Wealth has greatest exposure to managers who focus on balance sheet strength to provide a mix of income and capital growth – a strategy that gives clients’ income a degree of protection against the full extent of dividend cuts.

‘We like these funds as they have a bias away from the large caps, invest in market-leading cash generative companies and deploy disciplined valuation and dividend criteria,’ said Julian Menges, head of its Hardy managed portfolios. ‘Underlying companies have a healthy level of free cash flow cover relative to dividends and often repeat-purchase business models.’

7. AVOIDANCE OF VALUE TRAPS

Corporate resilience is a key consideration for TAM. ‘Companies emerging as survivors when the dust settles will have done so in part by consuming their own dividends. Income investors should be doffing their caps to these survivors because they will form the foundation of tomorrow’s income sector,’ said chief investment officer James Penny.

He points to the growing risk of income managers buying struggling businesses on high yields. ‘With so much disruption to supply chains, consumer spending habits, unemployment and ultimately bottom line profit, the risk of buying Covid-19 value traps is going to increase exponentially as sectors which usually produced high quality income generators fall foul of this new world.’

8. INCOME SUSTAINABILITY

How sustainable is the fund’s income? TAM prefers dividend growth over immediate income – ‘managers who look towards the goal of income tomorrow rather than just buying more of the few income generators still paying out today’, said Penny.

JM Finn prefers funds that pay a reasonable income with a history of growing payments in real terms – a strategy that tends to mitigate some capital risk.

‘Share price appreciation and long-run dividend growth appear inextricably linked so income sustainability, therefore, has value,’ said senior investment manager Scott Avent.

9. HIGH CONVICTION

JM Finn looks for funds with a high active share that run their winners – ‘holding on enables compounding effects to take place’, added Avent.

Charles Stanley also favours managers who have high conviction in their best ideas, so that they can have a meaningful impact on performance.

‘We aim to identify the key factor or “edge” of a fund,’ said investments analyst Rob Morgan. ‘Ultimately, we want to find a process that works and is repeatable, and we want to see that a fund manager sticks to it – even when the way they invest isn’t in favour.’

10. WELL-RESOURCED

Cathedral favours funds that are relatively small in size, but well-resourced and run by experienced managers. ‘We like managers who have sizable stakes in their own funds, aligning their interest with investors,’ added Bennett.

For Morgan at Charles Stanley, after diversification and consistency of style ‘it’s about excelling in terms of resources, quality of process and stock-picking record’.

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