MAY 2012 Investors turn to income
Equity income strategies are increasingly popular in the current low interest rate environment and Fidelity’s Enhanced Income fund is also looking for strong growth.
MICHAEL CLARK Manager, Enhanced Income fund, Fidelity
Reckitt-Benckiser and pharmaceutical companies, including AstraZeneca, Sanofi, GlaxoSmithKline and Roche. Every stock has be cash generative and able to pay its dividend.
A key focus of the group’s research is avoiding any company likely to cut its dividend.
The paucity of income in a low interest rate world is one of the most pressing issues facing investors. A number of solutions have been devised, but among the most popular has been the advent of enhanced income strategies.
Fidelity’s Enhanced Income fund was one of the first of these funds to launch and its higher yield, at over 7%, has found resonance with investors. The fund is run by Michael Clark and the underlying portfolio is based on the MoneyBuilder Dividend fund. The additional income is generated through a covered call option strategy on selected stocks in the portfolio. The fund receives a fee for giving away the right to part of the upside of a stock. This will cap the upside potential of some stocks in the portfolio, but the fee enhances the dividend yield, often by as much as 70-80%. For the Enhanced Income fund, the underlying portfolio yields about 4-4.5%, with the covered call option bumping up the overall income to 7%.
However, Clark is clear that the fund is not simply about generating high income. He also wants strong growth in that income, ahead of infla- tion. He also believes this income should not come at the expense of capi- tal growth.
This view is clear in the investment strategy. Clark says: “The core areas in which we aim to invest are those com- panies with a good dividend with the potential to grow. These types of com- panies have a lot of natural downside protection.
“We make a forecast on what a com- pany will look like in the future and want strong confidence in our predic- tions. This means we avoid cyclical businesses or those with excessive debt. We want companies that will be around tomorrow and will be bigger than they are today.”
This “safety of income at a reason- able price” strategy leads Clark to a portfolio weighted to sectors such as regulated utilities and classic defensive stocks such as tobacco and food compa- nies, consumer staples groups such as
Clark says: “We spend a lot of time with our analysts trying to identify those companies that are at risk of a cut. Companies don’t tend to cut by 5%, they will usually cut by 50% and this presents a real problem if that company is a large holding, disrupting the income flow on the fund.
“It was this that led us out of BP as the oil price fell.”
The fund tends to be structurally underweight financials and mining companies. Banks are unlikely to pay dividends for a number of years. While mining companies can be cash genera- tive, Clark believes there is a risk to their profitability if China is shifting its economy from capital investment to consumer spending.
He adds: “China is the only client that matters and metal prices might not go anywhere.”
At times, the fund will take a con- trarian view. Clark says: “Early this year, we bought Tesco. The value is the lowest it has ever been and it is now yielding 4.5-5%. The business will still be here in five years’ time and may be doing better than it is now. We thought that for those with patience, it could be a good opportunity.”
The covered call strategy sits above this portfolio. Clark is clear that the investment strategy will always lead the covered call strategy rather than vice versa.
For example, the fund has holdings of smaller companies in the portfolio, which have contributed to perfor- mance, but cannot be overwritten. The income generated by the port- folio versus that generated by the cov- ered call programme is around 60/40 and Clark over-writes around 60-70% of the portfolio.
In devising the options strategy, Clark works alongside David Jehan, a derivatives expert at the group. The managers use a labour-intensive approach, assessing each option on its own merits.
Clark explains: “If we are not get- ting enough income, we don’t write the option. We ran this as a model portfolio
for some time before launching in 2009 and I’m happy with our approach. We have never simply written options automatically.”
Clark believes this also helps min- imise the extent to which they cap the upside potential of the portfolio through the strategy.
‘ ‘ The core
areas in which we aim to invest are those
companies with a good dividend with the potential to grow.
These types of companies have a lot of natural
downside protection
The Enhanced Income and Money- Builder Dividend funds run alongside each other, so performance comparison between the two is straightforward. Clark would expect the capital return to be 1-2% lower for the Enhanced Income fund over time because of the capping effect. Investors are compen- sated by the higher annual income. He adds: “In falling markets, there may be periods when the Enhanced Income fund will do better for a period of time. One of the effects of the over- writing is that is dampens the volatility of the fund over time. It is a low volatil- ity fund anyway and it goes down fur- ther when the overlay is added. In general, sideways or slightly down markets are likely to be better for the enhanced income fund. In the “risk-on, risk-off” markets that we have seen recently, this is a good strategy.” Clark is clear that this strategy does not erode the base capital of the invest- ment, which has been a concern for some investors. The group’s research shows that the “naked” capital in the fund has kept pace with inflation or even improved since launch. Clark believes a number of factors favour an equity income strategy in the current climate. The first is that many traditional dividend stocks are now on significantly lower valuations than a decade ago.
He adds: “For example, the price to earnings ratio on GlaxoSmithKline has halved since 1997. This is true for other stocks of this type as well.”
He also points out that the yield on corporate credit is now, in many cases, lower than the equity yield.
He says: “Ten years ago, the corpo- rate bond yield on GlaxoSmithKline was 5.7% and the dividend yield was 2.6%. Now the numbers are 4.4% and 5% respectively. The same is true for Vodafone, Centrica and many other groups. This tells me that as long as earnings hold up, it is right to buy the equity over the corporate bond. “Equity income is a strategy that should do well even in a climate of weak economic growth.”
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