After a disastrous 1990s for the European Income portfolio, recent times have seen a bit of a revival. But what can investors do to avoid the mistakes that caused its previous demise?
“The Internet – we’re not interested in it”. This sound bite came from Bill Gates, and no doubt he argues it was taken out of context. The point is that just as the Internet had a slow start, European income funds have also had a difficult birth. But like the Internet, we are sure they are going to be a major force in the future.
I believe that European income funds work, but a series of European equity income funds came and went in the 1990s for various reasons. At its peak, there were 10 funds in existence that were run by notable firms such as Fidelity, Mercury and M&G. None have survived into the 21st century.
What went wrong with some of those funds is a good lesson for all investors, as well as the new entrants. Some of the funds suffered a structural drawback – they went for too high an initial yield, which resulted in low capital growth and low dividend growth.
Sales and marketing departments wanted a headline-grabbing advertising line, and tasked the growth fund managers of their European departments with the challenge of getting a high yield. In what was, compared with Britain, a low interest rate area, this seemed impossible. Rather than arguing for a lower, but growing, income stream, the easy option was either to buy a mix of low-yielding growth companies and bonds, or simply buy the highest yielders irrespective of their attractions. Either way, the income growth was likely to be poor, as was their capital growth.
Just when income stocks were about to come into their own as the dotcom bubble exploded, there were none around. The M&G European Dividend fund was last to go, despite dividend growth most years. The capital growth was fine too – returns compounding at above 12% a year over its 11-year life.
What about this time around? The number of income funds has increased, but we feel that exactly the same yield mistake is being made. Restricting fund managers to the highest-yielding areas means a lot of opportunities are lost.
Look at Nokia. In the late 1990s it was a darling stock, but fell out of favour and suffered years of de-rating and disappointments. By November 2006, it had a prospective dividend yield of more than 3% and that was the time to buy. It was low risk as a result of its low-rating, high-yield and abundant net cash in its balance sheet. Nokia then made a few good product announcements and the shares shot up 50%. At this point, the share’s dividend yield had dropped below a 2.5%, and that was the time to sell. Funds promising a net yield of about 4.5% would have found it difficult to buy this growth company.
So where should European income fund managers be investing now? There are several European yield stocks, but the highest yielders have plenty of dividend risk – as forecast with telecoms such as Telecom Italia, or no growth, like the TV and advertising companies. In both cases, the dividend is hardly covered by earnings and unlikely to grow for some time. The moderate dividend yielders and dividend growers tend to be the “busted” growth stocks of yesteryear, such as Wolter Kluwer (legal publisher) or Allianz (insurer). But as long as there is underlying growth, the shares should be fine.
The financials are the area of most intrigue. They represent about one-third of the market and have some of the highest yields, partly owing to the scares of “credit crunch”. There will definitely be some wounded companies, but many will get through largely unscathed. There are some quality ones that will get through with only a few flesh wounds, such as well-matched (assets and liabilities) retail and mortgage banks in places where excesses are not too apparent. This means being careful in Spain, Ireland and Scandinavia. In Scandinavia, the banks seem to have gone a little mad, issuing large quantities of euro-denominated mortgages in the non-euro Baltic states. Fine unless the euro goes up and the property market there goes down. European insurance companies look less likely to have difficulties than banks, as they suffered a lot in the 2000-2003 period from gung-ho investing and will have learned from their mistakes.
So what is the best way to use a European income fund in a portfolio? If you think earnings growth leads to dividend growth, then Ian Scott, European strategist of Lehman Brothers, says you should invest in Europe with its 15% earnings growth and 17% dividend growth in 2007 (paid in 2008), as opposed to Britain’s less exciting 12% and 6% respectively.
Looking at the Association of Private Client Stockbrokers and Investment Managers (Apcims) benchmark used by private client fund managers, the first thing to note is the heavy fixed income and UK equity elements. Any income growth comes from the income fund element. If you expand the equities a little by spreading into the (usually low volatility) European income arena, we estimate that the yield remains similar, but the income growth rate picks up. A crude estimate for the total returns (yield plus yield growth) suggests that returns for a portfolio in the lower table is higher in the long run. You also reduce single-country risk exposure to Britain.
Since the start of 2006, the European income funds have outperformed the government bond markets by a considerable margin. While they can underperform pure capital growth funds, they have a future giving low-volatility equity investments and growing income for people who would otherwise have to invest in fixed income securities.