Searching for yield in a difficult environment

6 July 2009

Q: Can you describe your investment strategy? How do you choose stocks?

A: We operate as a team and have a strong process that has been running for many years. The starting point is to look at our existing UK funds and their overweight holdings where the income is over 110% of the FTSE All-Share’s yield.

That is stage one and it covers the large stocks with the big yields. We then move on to stocks that have a weighting of more than 25 basis points of the index, which covers 80% of the market, and the yield is in excess of 110% and select stocks from these.

We then look at those that have less than 25 basis points weighting of the market but still yield 110% and select some from this bucket. We then look at stocks that yield 110% and then smaller companies with low yields but where we can see it is building up. The main priority is to meet the 110% yield requirement for the [UK Equity Income] sector.

Q: How much will the UK Equity Income fund overlap with other British retail equity funds at Aegon and the Distribution Life fund you have run since 2003?

A: It overlaps by about 40% with the UK fund, which is encouraging. It is a similar level with the distribution fund but the income element of that predominantly comes from the bond component, which is 50%. But they are not hugely different.

Q: Which areas or stocks are you favouring?

A: A lot of the names are common to most income portfolios such as BP and Shell. Some of the smaller and more interesting names are in the non-life insurance space.
We are underweight in financials but overweight in non-life insurance particularly some of the Lloyds’ companies such as Beazley Group and Catlin.

The outlook for non-life insurance is fairly benign unlike the banks and other financials. They make money from underwriting investment returns so the dividends are relatively secure. Beazley is yielding 7% and Catlin 8%.
The other attraction is they are inexpensively valued so offer decent capital appreciation.

We also favour Domino Printing, which is just under our cut-off point, with a yield of 4.9%, but the increase in dividend was 10% at the last reporting. It is a barcode company, which will prove fairly resilient.

In general retail we have taken a holding in Halfords. We have met the management many times and people think it is too defensive. It has proven resilient and is good at controlling costs. It also has opportunities to grow in Europe and is yielding over 5%. It is probably one of the highest and securest yields in the sector.

Q: Which sectors are not offering great yields at the moment?

A: It is difficult to find yields in resources, although I would say the UK desk is positive on the outlook for resources and commodities, so we have tried to get exposure. We are underweight in the sector but hold BHP Billiton. There is a lot of interest in smaller companies but they don’t pay yields so we have avoided them.

Financials is a major underweight through the banks. For Royal Bank and Lloyds the dividend outlook is uncertain at best. We also don’t have any technology exposure as it is a small proportion of the market and doesn’t yield much at all.

Q: Does the UK Equity Income fund have any fixed interest exposure?

A: We have put 3% of the fund into bond holdings. One position is in Xstrata for commodities exposure and another is in Royal Bank. That may not seem sensible but it is yielding about 7.5% and from speaking to my colleagues, holders of this bond rank on an equivalent basis to depositors so it is as secure as one would hope to get.

Q: Last year, many predicted 2009 would be tough for income investors. Would you agree that it has become more difficult as traditional yield companies such as financials have abandoned their dividends?

A: It has become more difficult and it will continue to do so. There is some interesting research from UBS that looked at dividends in larger firms in the FTSE 100 and the outcome was fairly confident on the outlook for continuing dividends. The number of larger companies that had never cut dividends was quite high and the big stocks with the high-dividend yields had a high certainty that they would pay. This included firms such as BP and Shell, which are yielding 8% a piece, and some pharma stocks. For lots of companies in the FTSE 100 there is a high degree of confidence that dividends will be paid.

Q: Do you see more companies cutting dividends to boost balance sheets?

A: There is a reasonable prospect of that. Last year we had lots of rights issues and then it went quiet again. Now rights issues and fund raiding are picking up again.
As companies go the banks to re­finance their debt and find the cost of borrowing has jumped, they look for alternatives. This includes asking equity shareholders for more money and is becoming fairly common.

However, if a company is going to be raising fresh capital, then it will be cutting dividends as it would be odd to ask for more money and then pay it out again. In some cases the dividend cutting has been done before the capital raising so the damage has already been done, but I am sure there will be more cuts and we need to keep an eye out and avoid those stocks.

Q: What do you anticipate the yield on the fund will be in its first year?

A: It is difficult to say. Not every stock will be yielding 110%, some will be a lot more and some lower.

I anticipate our portfolio yield to be about 115% of the FTSE All-Share. It is unlikely we will stretch the portfolio to aim significantly above that and 110% is a reasonably stiff income target.

We hope to be able to offer income and a portfolio of stocks that will follow some of those in more growth-orientated UK equity portfolio.

Q: What is your outlook for the British economy?

A: We are with the consensus, which is quite pessimistic.

We are looking at an election at some point in 2010 and spending pressures on the government could lead to higher taxation, putting public sector jobs under pressure. But I am not sure this translates to the UK stockmarket, where a good proportion of companies are international and the outlook for Asia and China is less bleak.

I also don’t think the market is expensive, so there is scope for some companies to prosper relatively as the UK economy goes through a rough patch.

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