UK income investors face a number of dark clouds on the horizon. Dividends are poised to fall as the cuts announced at the start of the year by companies, such as Rio Tinto (RIO), Glencore (GLEN), Standard Chartered (STAN), Barclays (BAR) and Rolls-Royce (RR), take effect. In addition, sluggish dividend growth and the possibility of market volatility if the UK votes to leave the European Union (EU) on 23 June, are fuelling investor anxiety.
In this kind of environment income-seekers need to focus on asset light, 'economic moat' type companies that are better able to withstand macroeconomic pressures, says Hugh Yarrow (above right), manager of TB Wise Evenlode Income Fund (GB00B40Y5R17).
He says: "What we always say about the macro policy is that we're looking to insulate the portfolio from the macro picture rather than predict it and place bets.
"We think of protecting the dividend stream from an uncertain future as we don't quite know what's going to happen to the global economy. There are always event risks."
The aim of the game is to choose companies which will be able to persist regardless of any kind of big political event, like the EU referendum, he believes.
Mr Yarrow, and co-manager Ben Peters (above left), favour low capital intensive businesses which generate a high return on capital, have strong balance sheets and good free cash flow. As a result they steer clear of oil and mining, utilities, telecoms, banks, insurers and property companies.
"If you look at the history of dividend cuts in the market they tend to come from a combination of economic sensitivity, high levels of leverage and high capital intensity, so that's why we skew ourselves away from those kinds of sectors and towards more cash generative ones where the balance sheets tend to be stronger," Mr Yarrow explains.
International diversification is also important to ensuring an inflation-proofed dividend stream over the long term, he says. Although the fund invests primarily in UK listed companies, he deliberately focuses on globally run businesses - even at the mid cap level - to protect against UK specific political and economic risks.
He says: "It's actually quite a global portfolio with only about 20 per cent of underlying cash flows coming from the UK economy. That's partly because the sectors that tend to have the economics we like - consumer branded goods, healthcare, media and software - are global in nature. But we also actively have a preference for more global businesses because they are more diversified."
They like investing in well established brands that operate with a repeat purchase business model, or companies which produce what Mr Peters describes as "mission critical type of products."
These include Rotork (ROR), which manufactures actuators used in power plants, as well as consumer staple companies such as Diageo (DGE), Johnson & Johnson (JNJ:NYQ) and Procter & Gamble (PG:NYQ).
Mr Peters says there are also interesting opportunities in the mid cap sector, such as Victrex (VCT) and Aveva (AVV), which the fund added at the start of the year.
Both managers are particularly excited about Aveva - a subscription based business which sells software to engineering consultants - on the grounds that it offers income investors the holy grail of dividends today and in the future.
Mr Yarrow says: "Because the growth environment is quite difficult, I think there has been a tendency or temptation for companies to cut back on investment because every pound you spend today on investment is a pound off your short-term earnings.
"So when we find a company like an Aveva where culturally they've got that tendency to want to keep looking to the future to develop their franchise, it's a really nice place to be - particularly if they've got the cash generation to fund that while also funding a healthy payment and dividend growth."
Standing by sustainable yields
The balance between yield and growth is something that's just become personal for Evenlode's managers. Last month the fund was ousted from the UK Equity Income sector, after narrowly falling short of the Investment Association yield requirement.
The managers have contributed to the IA's consultation on the sector's yield requirement and Mr Yarrow is keen to stress the fund's recent removal will not affect how it is run.
He hopes to re-join the equity income sector in the future but says ultimately long-term investors should aim for sustainable income rather than chasing high yield.
"If you just have a high yield today but it's unsustainable that's no good, but equally if you have a very low yield, with very good growth that's not necessarily going to provide a meaningful, inflation proofed dividend stream over the long term," he says.
"Our approach is about dividends today but [also] dividends in the future. And we think it's the combination of those two things which are really important for the long-term saver."
Hugh Yarrow and Ben Peters CVs Hugh Yarrow launched TB Wise Evenlode Income Fund in October 2009. Between 2002 and 2009 he managed several equity income funds at Rathbone Unit Trust Management, having graduated from the University of Edinburgh with a first-class degree in philosophy and mathematics. He is a fellow of the Chartered Institute for Securities and Investment and holds the Investment Management Certificate. Ben Peters has been co-manager of Evenlode Income since December 2012 and previously an investment analyst at the fund since its launch. He is a member of the CFA Society of the UK and holds the Investment Management Certificate. He also holds a doctorate from the University of Oxford and a first-class degree from University College London, both in the field of physics. |
