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New-look income funds

As the table shows, even as limited an investment pool as the FTSE 100 can provide the core of an equity-income portfolio. Come to that, it could provide the core several times over. There is nothing that special about the 10 selected, so, if I did this exercise ‘x’ times, each time I could come up with a substantially different 10.

Ten for starters
 Share price (p)% 5-yr highPrice relative*Mkt Cap (£m)PE ratioPrice/FCF†Div yield (%)Pay-out ratio (%)
GlaxoSmithKline1,580852779,28314155.169
Diageo2,796776265,35426na2.462
Rio Tinto4,7489411259,18711105.966
Unilever4,678887354,66421203.269
Tesco22183821,61417na3.559
Persimmon2,46374367,85613154.356
Mondi1,4426447,00214204.564
Avast57194na5,85322182.043
Severn Trent2,42289205,78223na4.297
RSA Insurance4416554,56311136.267
Average of 10 81  17 4.165
* Price/FTSE 100 (5-yr change, %), † Price/free cash flow;  source: FactSet   

True, GlaxoSmithKline (GSK) and Unilever (ULVR) would make the cut almost always; at least, while the macro-economic outlook remains so uncertain. The rehabilitation of Glaxo’s reputation has been remarkable. Sure, investors now spot that the consumer healthcare side is really a mini-Unilever waiting to be released (that happens when it is spun off in 2022). Also, the effect of treating Covid-19 should, somehow or other, be good for the pharmaceuticals side. But group-wide little has actually happened yet to improve performance.

Ditto Unilever, or to an extent. The great merit of the Anglo-Dutch consumer-necessities group is that its turnover comes in small-ticket, cash-purchased items. But for years City analysts could not see beyond the group’s pedestrian sales growth from a product portfolio forever in transition and somehow a bit patchy. Something similar might be said of the drinks conglomerate, Diageo (DGE). But while the force is with these three, they could provide the core of an income portfolio for the new normal.

The other seven of the 10 are moveable items. Rather than Tesco (TSCO), there could just as well be another supermarkets operator; instead of Persimmon (PSN), another housebuilder; rather than Severn Trent (SVT), another utilities provider. And so on.

Granted, the paucity of technology stocks in the FTSE 100 means the choice is between Avast (AVST) and Sage (SGE). Neither of these offers much in the way of income, even in these straightened times; but their 2 per cent-plus yield is more than double the only other contender, Aveva (AVV). Besides, as sectors cycle in and out of fashion, it is almost always important to have representation across many industries in any portfolio; perhaps particularly one that focuses on income/yield as it is drawn to areas where growth often struggles to be maintained.

Still, what this rough-and-ready exercise produces is the core of a portfolio that is well diversified and offers a 4.1 per cent yield on forecast dividends for 2020 that, on average, absorb 65 per cent of available accounting earnings (in other words, dividend cover is 1.5 times). That compares with a FTSE 100 average of a 3.1 per cent prospective yield on a pay-out ratio of 56 per cent (1.8 times cover).

While 1.5 times cover looks quite plump compared with the UK average going into the Covid crisis, it may not be acceptable in the new normal; particularly as I suggested earlier this year (Bearbull, 17 April 2020) that in this dystopian period a company’s ability to maintain its dividend should be assessed in relation to its likely free cash flow rather than its accounting profits.

I might also speculate that a 4.1 per cent prospective yield is unrealistically high. After all, it is more than 1.3 times the FTSE 100’s average and I have always run the Bearbull income fund with the loose aim of generating 1.2 times the Footsie’s average. Nowadays even 1.2 times might seem excessive – why should a sensible investor take the risks needed to capture a 3.7 per cent income yield when inflation is crawling along at barely 1 per cent? Feasible answers would be because, first, official measures of inflation – always questionable – are especially suspect during these times of such odd spending patterns and, second, the way the developed world’s treasury departments and central banks are playing fast and loose with their currencies is inherently inflationary.

Then again, if – in the interests of prudence – the yield target were cut to just 1.1 times the yield on the broad index, it is debatable whether it would be worth the time and effort to research and run a portfolio. It might be easier to put the capital into an exchange-traded fund that tracks a high-yield index; for instance, Wisdom Tree UK Equities Income (WUKD) or – for an international flavour – Vanguard FTSE World High Dividend Yield (VHYL).

But what would be the fun in that? My present inclination is to extend the scan to the FTSE All-Share index then dig into some company-specific number crunching to find a new-look Bearbull income fund. More of this in the coming weeks.