Hugh Yarrow: Evenlode is equipped for a new economic cycle

Yarrow Hugh Evenlode 2014

In recent weeks, investor expectations for inflation and interest rates have risen rapidly. This has partly been due to the prospect of post-election fiscal stimulus in the US (both from infrastructure spend and tax cuts) and partly due to a recovery in commodity and energy prices.

As a result bond yields have moved higher – from a very low level earlier in the year – and there has been a rotation in the stock market towards financial and commodity stocks. At the same time, the share prices of many predictable dividend payers have fallen back due to their perceived similarities to fixed coupon bonds.

Below are three key reasons why we think the Evenlode Income portfolio would, in fact, be well equipped to deal with an environment of rising inflation and interest rates if this scenario were to transpire over coming years.

Cash generative business can provide inflation proofing  

The potential for real growth in capital and dividends over time is something that the equity of competitively advantaged companies has in its favour – and also something not enjoyed by fixed coupon bonds. Evenlode’s cash flow stream derives from competitive advantages from vaccines to academic journals to mission-critical engineering products and monitoring systems.

These goods and services should remain in demand over time and often have strong customer loyalty, helping them retain their pricing power (in both deflationary and inflationary conditions).

Inflation in the modern world of paper money has in fact been quite persistent since the pound decimalised in 1971. £1’s purchasing power has declined by more than 90 per cent in the intervening 40 plus years. So, companies have been dealing with inflationary pressure for decades – the last few years of low inflation are something of an outlier. Over and above inflation-proofing, cash generative equities can also consistently invest in innovation, product range expansion and geographical diversification, something I have often discussed in these views. This provides the potential for compounding real growth over time.

Potential for dividend growth

It has been a strange few years for the bond market. While the equity market has seen some yield compression, it has been by no means as extreme, and a combination of dividend growth and valuation management has meant that Evenlode’s yield has remained fairly stable over the last few years.

Taking a longer-term perspective, it’s worth remembering that there have been plenty of periods in the past when bond yields traded at or above equity dividend yields – the large yield premium that equities have exhibited in the last few years is by no means the ‘normal’ state of affairs. And in many ways, that makes sense, given the real potential for dividend growth that equities are able to offer investors.

Balance sheet strength insulates investors from rising borrowing costs

Ultra-low bond yields combined with low economic growth have led UK businesses in aggregate to take on more debt. Managing the balance sheet strength of the overall Evenlode Income portfolio and biasing the portfolio towards self-funding businesses has been a particular focus for us over the last couple of years. Low levels of debt in the portfolio help insulate it from the risk of rising borrowing costs if and when interest rates rise.

No perfect hedge against inflation

Clearly there is no perfect hedge against inflation. But a collection of asset-light, competitively advantaged companies are not simply a ‘deflation bet’, but should cope well with rising inflation too.

Though the higher inflation/interest rate narrative is becoming consensual again (as it has several times over the last few years), it’s worth holding the thought that there is a very credible scenario in which deflationary pressures retain their grip on the global economy for some time.

Various structural factors are unlikely to dissipate in the medium term including a high stock of global debt (for which even a small rise in rates will create problems), demographic trends and innovation. In my view, therefore, protection from uncertainty via a collection of good, diversified businesses is more important than a big binary bet on either the inflation or deflation narrative.

Hugh Yarrow is fund manager for Evenlode Income.