Investors looking for income can earn a competitive yield from all corners of the market, says Nick Sudbury
Return of the King
Neil Woodford is one of the most highly regarded managers of his generation, and he has recently returned to the market with a new Equity Income fund that bears his name. He intends to use the same investment process as he did with Invesco Perpetual Income, where his 23 year reign produced an annualised cumulative return of 14.3% compared to a sector average of just 9.3%.
Woodford Equity Income aims to offer capital growth with a rising income stream, paid quarterly. It will mainly invest in the UK, although up to 20% can be held overseas, with the objective being to generate 10% more income than the FTSE All-Share. This would be equivalent to a current yield of 4.0%.
The investment process is designed to identify companies that are undervalued relative to their ability to generate cash in the prevailing economic conditions. Woodford and his team will then invest where they believe that this will lead to a re-rating of the shares. As with Woodford’s previous funds, there is a big emphasis on capital protection: it was this approach that enabled him to avoid the worst of the fallout from the dot com bubble and the 2008 financial crisis.
Woodford is fairly cautious about the market as a whole, but he has a great track record when it comes to stock selection. It is likely that the bulk of the portfolio will be invested in well-established companies with decent yields, although there will also be some smaller caps that offer the potential for strong capital growth.
Starting his own investment management firm is a bit of a gamble, but Woodford’s reputation is such that he should have little trouble in attracting enough capital to keep it cost efficient. The fact that he has recruited several of his team from Invesco Perpetual should ensure that he is not spread too thin.
CF Woodford Equity Income is bound to incur higher transaction costs as the initial wave of capital is invested. Having said that it is not often that you get the chance to get in at ground level when a proven manager makes a fresh start. It is hard to think of a safer pair of hands for your clients’ money.
Name: CF Woodford Equity Income Fund
Type: UCITS (UK)
Sector: IMA UK Equity Income
Fund size: n/a
Launch Date: June 2014
Target Yield: 4%
Ongoing Charges: 1%
Manager: Woodford Investment Management
The Appliance of Science
Liontrust Global Income
Clients who are looking to diversify their sources of income overseas may be interested in Liontrust Global Income. Originally the fund had a UK-only mandate, but it was changed last July and now has around 43% of its portfolio invested internationally. The managers mainly concentrate on high yielding shares, which explains why it is currently paying around 4.5%, with distributions made twice a year.
James Inglis-Jones and Samantha Gleave use a proprietary investment process known as the Liontrust Cashflow Solution. This is designed to ensure that they only buy high yielding stocks with unusually strong cash flows where investors have low profit expectations. It does this by concentrating on two main measures: cash flow relative to operating assets and cash flow relative to enterprise value. They then use this to rank their global universe of stocks.
The companies with the best combined score have a higher cash flow yield and a better cash return on operating assets, which is usually a reliable indicator of outperformance. Inglis-Jones and Greave then research the top 20% to make sure that the data is indicative of the type of forecast errors they are hoping to exploit, and to ensure that the shares offer a decent yield.
One of the most surprising − and welcome – results is the concentrated nature of the portfolio. There are currently just 26 holdings, with the top 10 accounting for around half of the £252m fund. These include: Restaurant Group, AstraZeneca, Next, Total and British Sky Broadcasting.
It is very much a bottom up, stock picking approach, with little emphasis on the top down asset allocation. This explains why just under 58% of the portfolio is invested in the UK, with the remainder divided between 10 other countries in North America, Europe and the Far East.
Liontrust Global Income provides exposure to a concentrated global list of companies that pay generous dividends and that are supported by strong balance sheets and robust cash flows. This should be a decent approach, given that the equity markets are not likely to be as buoyant as over the last few years – in which case the income will make up a significant proportion of the total return.
Name: Liontrust Global Income
Type: Unit Trust
Sector: IMA Global Equity Income
Fund size: £252m
Launch Date: July 1990
Ongoing Charges: 1.67%
Manager: Liontrust Fund Partners
A winning strategy
Jupiter Strategic Bond
More conservative clients, and those for looking for a higher yield, would typically use a fixed income product. Given the risk of rising interest rates, the safest option would probably be a strategic bond fund, where the manager has the freedom to invest in whichever parts of the market he sees fit, as long as at least 80% of the portfolio is denominated or hedged back into sterling.
A good example of this type of product is the Jupiter Strategic Bond, which aims to achieve a high income with the prospect of capital growth. Over the five years to the end of April the accumulation units are up 97.2%, while the income units are yielding 5.7%, with distributions being paid every quarter. These impressive returns show what a good time it has been to be invested in fixed income, although the manager is more cautious about the current conditions.
Ariel Bezalel, who has managed the fund since it was launched, has developed an interesting top down/bottom up strategy. This involves spending a lot of time researching the company fundamentals, while also looking at macro factors such as inflation, interest rates and the shape of the yield curve to decide how to position the portfolio. It was this approach that led him to invest in Lloyds Bank bonds, so as to benefit from the company’s return to profitability.
Currently almost 40% of the £2 billion fund is invested in the UK with a further 32% in Europe. There is also 8.5% in the Far East ex Japan – mostly Australian government bonds – and 7% in the US. The average credit rating is BB+, which is just below the investment grade threshold, and the portfolio duration is a short 2.16 years. In total there are 324 individual holdings, with the top 10 accounting for 16.4% of the fund.
The short duration is intended to limit the negative impact of higher interest rates, while the low credit rating reflects the fact that the best opportunities are to be found in European high yield bonds where companies have been busy repairing their balance sheets. This shows that it is a cleverly managed fund with a go anywhere mandate and the past performance suggests that investors have been well rewarded for the active risk.
Name: Jupiter Strategic Bond
Type: Unit Trust
Sector: IMA Sterling Strategic Bond
Fund size: £2,031m
Launch Date: June 2008
Ongoing Charges: 1.49%
Manager: Jupiter Fund Management
Off the beaten track
BlackRock Commodities Income Investment Trust
There is a growing concern that the search for yield has pushed the value of many income generating assets into dangerous territory. One way to get round this is to look further afield – and it is hard to think of a less likely option than commodity funds. Yet some of these products pay healthy dividends. It has been a difficult three or four years for the sector, but many natural resources companies now look to be decent value – unless, that is, you feel that the slowdown in China has a lot further to run.
A good option is the BlackRock Commodities Income investment trust. BRCI invests mainly in mining and energy stocks and aims to achieve an annual dividend target together with long-term capital growth. Last year it paid out 5.95p per share, which was equivalent to a yield of 5.2% with quarterly distributions. Despite the high pay-out, the investment trust is only trading on a small 2% premium to its NAV.
The £116 million portfolio currently has 36.4% invested in integrated oil majors with the largest holdings including the likes of Chevron, Exxon Mobil, Total and BP. There is also 12.5% in Oil Exploration and Production, where the managers have a strong bias to US shale gas, as well as a further 9.5% in the remainder of the Oil & Gas sector.
Looking at the rest of the portfolio, the next largest exposure is the 20.6% weighting in mining stocks, where BHP Billiton and Rio Tinto make up 9.3% between them. The other key holdings include a 7.4% allocation to copper and 5.5% in gold bullion, while the principal geographic split is: 30.2% US, 22.9% Canada and 19.3% UK.
BRCI has a decent long-term performance record with a 5-year return of 32%. Since the fund was launched in December 2005 it has consistently grown its dividends and has built up revenue reserves of 3.3 pence per share, which equates to more than half of the 5.95p target pay-out for the year. About a third of the income typically comes from writing covered options on the underlying stocks, although this is more of a company-specific strategy rather than a systematic approach.
The managers are fairly optimistic about the outlook, largely because of the pick-up in global growth. They also think that mining and energy companies offer good value compared to the wider market. BlackRock Commodities Income is clearly a higher risk option than most of the other income generating funds, but it could have a lot more upside potential if the world economy continues to recover.
Name: BlackRock Commodities Income (BRCI)
Type: Investment Company
Sector: Commodities and Natural Resources
Market Cap: £116m
Launch Date: December 2005
Current Yield: 5.4%
Net Gearing: 7%
Ongoing Charges: 1.4%
Manager: BlackRock Investment Management