In this article published in The IRS Report in June 2010, Chris Gilchrist discusses global equity income...

Global equity income is the theme of the next decade

Value investing is the investment strategy with the longest pedigree and the strongest record of success, according to the Credit Suisse Global Investment Returns Yearbook. The figures are so striking that they are worth repeating. Between 1900 and 2007, £1 invested in the UK equity market average would have grown to £22,252, an annualised rate of a nominal 9.7%. Lowyielding or growth stocks produced a lower return of 8.2%, converting £1 into £5,134. Highyield, normally taken as a proxy for value stocks, achieved 11.2% with a final value of £95,868. In the long run, the study’s authors show, value is investors’ most certain route to wealth.

Both Douglas Moffitt and Peter Shearlock apply value investing in their contributions to The IRS Report, and for those who want to buy it as a package in the form of a fund, Mark Dampier has previously featured UK Equity Income funds. While these have rarely been “top of the pops” in terms of the annual league tables, they have almost never featured in the “doghouse” fund lists either.

But the 2008-09 debacle also focused managers’ minds on a major problem: a diminishing number of companies are responsible for the bulk of UK dividend distributions. The collapse of bank dividends, which pre-crunch accounted for a quarter of FTSE 100 dividends, means that BP, Vodafone, GlaxoSmithKline, Shell, HSBC, BAT and a few others now account for two-fifths of all Footsie dividends.

This means managers of UK equity income funds have to choose between concentration of their portfolios in the “megacap” stocks or moving to a much wider portfolio reaching down into the FTSE 350. But liquidity in the lower reaches of the 350 Index can be problematic even for a £500m fund and some equity income funds are several times that size. So we now see the most successful of the UK Equity Income managers, Neil Woodford, holding 15% of Invesco Perpetual Income’s capital in three tobacco stocks – BATs, Imps and Reynolds – and 15.5% in the UK’s two “big pharma” stocks, GSK and AstraZeneca. Newton, Schroder and JPMorgan were among the first to realise that this problem presented an opportunity and in 2007 launched global equity income funds aiming to apply the same methods to a wider universe of stocks. Since then they have been joined by several others including M&G, Invesco Perpetual, Baillie Gifford, Sarasin, Lazard and Threadneedle. As the table shows, performance data is too limited to draw any firm conclusions, but over the latest 3 and 6 months most funds have achieved returns closer to the MSCI World Index than to the Footsie. The funds listed each hold between £40m and £1bn in capital.

The spread of yields suggests we are seeing the same differences in tactics as has been evident with UK Equity Income funds. Some managers are buying a lot of defensive highyielding shares; others are using a “growth of income” approach more similar to that which Douglas Moffitt applies in his Rising Income Retirement Portfolio. Newton has generally held a higher proportion in emerging markets than world market capitalisations would suggest, which has worked to its benefit until recently.

Most funds restrict themselves to large-capitalisation stocks. Invesco  Perpetual has the highest percentage (89%) in stocks capitalised at over £10bn; Threadneedle and Newton have least at 59% and 70% respectively. Probably more significant in terms of short-term performance is exposure to the US: M&G, with 46% in North America, is top of the short-term league table, while Newton with 20% is at the bottom. None of the funds appear to have taken on big exposure to any one sector, with percentages in consumer goods varying from 11% to 20%, in oil and gas from 8% to 13% and in healthcare from 6% to 13%. Telecoms is the sector with the widest dispersion, Invesco Perpetual holding 7% and Newton 17%.

M&G with half a dozen individual holdings at the level of 3% or more of the portfolio, is the most aggressive of this set of funds. Most managers restrict their maximum holding to the 2% level, a far cry from the top ten lists in alpha funds where 5%+ holdings are common. Reynolds, Vodafone and Zurich Financial Services are the only names to feature in the top 10 lists of three or more fund portfolios, a reflection of the fact that at the £10bn capitalisation level, the investable universe in developed markets is over 400 stocks, and a big contrast to the wide overlaps in top 10 holdings between UK Equity Income funds.

Only two funds, JP Morgan and Sarasin, hedge their portfolios into sterling. Picking winners in this group is a tough call. On the face of it, there is not a lot to choose between M&G, JPMorgan, Schroder and Threadneedle, though most would rate M&G the weakest in terms of its UK equity income fund performance. Perhaps JPM and Threadneedle should have an edge because of their larger global footprints. Newton, with its strategic higher emerging market exposure, and M&G, with its higher US exposure, seem likely to show the highest volatility. Probably the deepest value practitioners are Invesco Perpetual, JPM and Schroders, and these would be my own choices.

A continuing strong economic recovery will almost certainly see the returns from these funds lagging those of growth-oriented rivals. But I think it is worth recalling that after Japan’s own 1990 crunch, defensive stocks outperformed the market averages for a whole decade. Investing in big, mainly global companies selected for strong finances, brands and  management, is a “safe haven ”approach that seems likely togenerate good returns over the next 5 to 10 years without many sleepless nights.

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