The fall-out moment

Anyway, the illustrious corporate name in the frame for the income fund is Tesco (TSCO). At 341p, its shares are among just 35 of the 603 components of the FTSE All-Share index whose price is within 20 per cent of its five-year low. Alright, given Tesco's much-publicised woes since its previous chief executive, Sir Terry Leahy, so beautifully timed his retirement in March 2011, it's understandable that its share price should be touching such harrowing levels. Yet from that follows the rather predictable question: with the share price deeply unpopular and the dividend yield so - relatively - high, do you buy the shares for recovery?

When a great company falls from grace it's a matter of when, not if, that question gets asked; then gets repeated time and again. In the case of the 'other' great British retailer, Marks & Spencer, it was really the only question asked in the 10 years following the departure of Sir Richard Greenbury in 1999.

True, Marks never convincingly recovered its magic touch, but that has not prevented its shares from performing decently. On one interpretation that was only because the company was paying dividends that ultimately became unsustainable (and the pay-out was cut in 2008-09). I don't buy that argument. During the best years of what looked like a revival under the leadership of Sir Stuart Rose, Marks paid a rising dividend that was covered by its free cash flow. But the point of this digression is to show that owning shares even in a once-great company that does not return to its glory days can still be a sound move. Anyone who bought M&S shares for 295p at the turn of the millennium - when what we might label 'the Greenbury fallout' was at its deepest - would have done okay. With the price of the shares now 463p, and including all the dividends received, their internal rate of return (IRR) would be 6.7 per cent. Technically-minded readers will know that the IRR is the discount rate that sums all the cash flows to zero. The important point to grasp is that it's an acceptable - though hardly exciting - return.

If Tesco's shares are in the trough of their 'Leahy fallout', then buying a holding now could produce something similar or better. It looks feasible. For starters, there is no obvious sign that the dividend is under pressure. City analysts expect a pay-out for 2013-14 of at least 15p from earnings clear of 30p. More important, free cash flow per share has averaged 25.6p over the past five years. The lumpy nature of capital spending means there is much variation around that average, but in only one year - 2008-09 when it was 5.2p - has Tesco's free cash been below this 15p base level. That amount would produce a 4.4 per cent dividend yield, which is a decent starting point in pursuit of an 8.5 per cent annual return (the Bearbull income fund's IRR target).

Sure, Tesco has major operational issues, which I won't touch on here. Yet, while it tackles these, its retail juggernaut keeps trundling out enormous cash flows that drive down borrowings. At the very least it's easy to accept that Tesco's shares are far more sensibly priced on their current 11 times forecast earnings than their rating in the mid to high teens when Sir Terry was judged capable of producing a global retailer to rival Walmart.

Besides, I rather like the idea of a holding in Tesco complementing one in GCP Infrastructure Investments (GCP), the closed-end fund that I wrote about last week. These two could help replace some of the income fund's holdings in Carr's Milling (CSM), where the weighting has become too big (it's 21 per cent of the fund), Carillion (CLLN), which has dropped through its stop loss, and iShares £ Corporate Bond (SLXX).

And their presence would enhance the fund’s income yield, which has become an issue. In the first half of 2013 the yield dropped to 3.9 per cent (see table). True, that's partly a function of success - the fund's value is 17 per cent higher than 18 months ago and 8 per cent up in the first half of 2013 (both figures better than the All-Share's performance). Nor can I be too worried when the fund's distribution in the first half was 9 per cent higher than 2012's first half. Even so, to meet my objectives, the fund's yield should currently be about 4.1 per cent.

It all adds up to a burst of dealing activity soon.

Income Portfolio distributions