Escape route

Neil Woodford swapped a reputation as the only UK investment manager with star dust for that of something between a clown and a fake. Most likely, neither reputation was deserved. Still, at the height of his celebrity, he suggested that the modern income fund should comprise a combination of conventional high-yield stocks sprinkled with blue-sky situations that would eventually provide the fund with its oomph.

Because this was the suggestion of the UK’s best-known investor, the commentariat gave it due respect. But when the bottom fell out of Woodford Investment Management in 2019 – and the chaotic nature of its funds was revealed – Woodford’s notion was treated as ridiculous.

Actually, there was some sense in what he was saying. Put it this way, there is a weary familiarity about the average UK-orientated income fund, largely because the same old culprits keep cropping up; companies whose best days are almost certainly gone, operating in industries that won’t necessarily disappear – surely, there will always be a need for, say, builders and food manufacturers – but often struggling even to cover the cost of their capital. Similarly, there will always be a need for banking, insurance and energy. But innovation means those companies scrabble around for acceptable returns from markets that may be transformed by the 2030s.

Therefore, what the average income fund needs is, perhaps, not star dust, but the investment equivalent of a little yeast to do the leavening. That, roughly speaking, is the purpose behind Table 1.

By way of quick background, the Bearbull Income Portfolio is in need of some replacement holdings. Including this week’s sale of its holding in Haleon (HLN) – see below – about 15 per cent of its £265,000 is in cash, with a further five percentage points likely to be added from the sale of its holding in specialist insurer R&Q Insurance (RQIH), which has axed its dividend.

So Table 1 divides into three – companies whose shares offer an ultra-high dividend yield, those simply offering a high yield and those whose yield isn’t necessarily more than the 3.5 per cent average for the FTSE All-Share index.

Clearly, the safety of the dividend lying behind the yield exists in inverse proportion to the yield. In other words, where ultra-high yields rise, the chances that the dividend will materialise falls. Even where paid, the chances that it will grow also diminishes. That’s how it is. An ultra-high yield is there for a purpose – to warn off investors. That said, three of the four in the table offering an ultra-high yield do so on a pay-out that, according to City forecasts, will be comfortably covered by earnings. The exception, pensions administrator Chesnara (CSN), a former Bearbull holding, has a track record of paying out almost all of its predictable net profits as a dividend.

As yields fall then, implicitly, the quality of companies behind them rises. That is why much of the table’s focus is on those companies whose yield is no more than ‘acceptable,’ since these should be the ones that will provide the Bearbull fund’s all-important leavening.

In practice, the fund has been heading towards becoming a two-tier entity anyway. Ten of its 13 holdings, which make up 70 per cent of its value, are divided equally into two camps. There are five that offer a high yield on reliable dividends that won’t grow much, if at all. These are holdings in NatWest Prefs (NWBD), Williams Companies (US:WMB), Primary Health Properties (PHP), Real Estate Credit Investments (RECI) and Greencoat UK Wind (UKW), whose weighted average yield in the fund is 6.0 per cent. Meanwhile, another five – GSK (GSK), Record (REC), Vesuvius (VSVS), Henry Boot (BOOT) and Devro (DVO) – will hopefully provide the lion’s share of capital growth, though their weighted yield is just 4.0 per cent.

That trend may well continue when I look in more detail at some of the companies in the table. Not that high and ultra-high yield stocks should automatically be excluded. For instance, among the ultra-high yielders, it wasn’t that long ago the Bearbull fund had a holding in tiles retailer Topps Tiles (TPT), which – whatever its sensitivity to falling consumer spending – has a great presence in its niche.

The fund should also be attracted to those companies where there is positive price momentum – measured in the table by performance relative to the All-Share index over the past three months – and have a high Piotroski F-score, which is a short-hand ready-reckoner for totting up a company’s profitability, balance-sheet strength and operating efficiency. True, these are marginal considerations, but is it a coincidence, for example, that Morgan Advanced Materials (MGAM) has both the best price momentum in the table and the highest F-score? It helps that the specialist in industrial ceramics, seals and braking systems has just released good results for the first half of 2022 and its bosses say full-year earnings will be at the top end of City forecasts, indicating something over 30p per share and a rating of little more than 10 times earnings.

Morgan will, therefore, be one to look at more closely, as will retailer Pets at Home (PETS) and chemicals specialist Johnson Matthey (JMAT). It will be tempting to add another – and very different – chemicals specialist, Victrex (VCT), if only because shares in this polymers maker sit below their five-year average for both price to forecast earnings and cash flow. Sure, at 20 times forecast earnings that is still not a low rating for an income-fund holding. Nor is the prospective 2.8 per cent dividend yield acceptable for an income fund. Then again, if the underlying pay-out, which is twice covered by forecast earnings, continues to grow at 6.2 per cent a year for the next 10 years, as it has done for the past 10, that would probably work out fine. To be continued.

Every company boss who plans a major corporate re-organisation should first be compelled to learn and recite three times a day these famous words from Petronius Arbiter, the chief adviser to the Roman emperor Nero: “We trained hard, but it seemed that every time we were beginning to form up into teams we would be re-organised. I was to learn later in life that we tend to meet any new situation by re-organising, and a wonderful method it can be for creating the illusion of progress while producing confusion, inefficiency and de-moralisation.”

Though 2,000 years old, this advice remains fresh and – to judge by the evidence – almost totally ignored by company bosses, who love a good re-organisation only slightly less than they love the thrill of deal-making. As such, I wonder how much attention Emma Walmsley paid to it as she led the drawn-out corporate bisection of pharmaceuticals conglomerate GlaxoSmithKline into GSK, where she is the chief executive, and Haleon, a toothpaste to pain-killers business.

Intuitively, everyone knows Haleon is now sitting there waiting either to suffer the enervating effects of diminishing economies of scale or to be a bigger company’s meal time. Just a glance at Table 2 indicates it has only a slim chance of long-term independence. Of four would-be suitors shown – and there are others – only Colgate-Palmolive (US:CL) would have minor difficulty funding a deal and Walmsley has already rejected an approach from Unilever (ULVR).

The question for Haleon’s private-investor shareholders, therefore, is whether to wait for the takeover bid or sell the equivalent of a stub equity holding. After all, for every £20,000-worth of shares they held in old Glaxo they got about £3,500-worth of Haleon shares, whose value isn’t necessarily underpinned by takeover hopes. There is also the question of what happens to the 32 per cent of Haleon owned by Pfizer (US:PFE), which is subject only to a short-term lock-up. Pfizer might end up either as a deal maker or a deal blocker.

Investors with no alternative use for the comparatively small amount of capital involved may decide to wait and see. However, with next-to-nothing of a dividend on offer, Haleon’s shares are wrong for an income portfolio so the Bearbull fund has sold its small holding at a fraction below 311p per share.

bearbull@ft.com