MAY 2012 Reliable growth is the key
There is an abundance of high-yield UK companies and Jupiter managers believe investors should be looking for growing income by choosing businesses where profits are depressed.
ANTHONY NUTT (L) AND PHILIP MATTHEWS (R) Fund managers, UK equities team
Global income may be fashionable, but it is easy to forget that the UK has some of the most robust and attractive high-yield companies in the world.
Jupiter’s Anthony Nutt and Philip Matthews, managers on the Jupiter Income trust, say they believe the cur- rent climate is particularly suited to this type of company.
Those that are paying a yield sig- nificantly in excess of that available from bonds, yet have a business model well-adapted to the recession- ary environment, are likely to reward investors with patience. There is a compelling long-term case for prioritising dividends. Nutt points out that over the past decade dividends have done a lot to protect investors’ capital from the swings in equity markets.
He says: “Markets are now a long way from the high in the All-Share at the end of 1999. However, UK equity income is only around 10% behind that high. If you look at a total return basis, dividends have mattered sig- nificantly to investors.”
There is also a natural contrari- anism and risk management in divi- dend investing.
Matthews says: “Income investors are often investing where profits are depressed, where the bad news is in the price, rather than buying into peak profits and peak margins. “This is a stable foundation for investment. There is much more downside protection if the valuation is at an all-time low and based on profits which are not over-inflated.” There is also a good shorter term case for income investing. In par - ticular, equity income now looks attractive compared with other potential sources of income, such as fixed income.
Nutt points out that interest rates are at a false level and there has been a transfer of wealth from savers to borrowers.
As a result, he believes seeking stocks with dividend growth is likely
to prove far more secure in the long term than seeking the false security of artificially inflated fixed income markets, particularly in the sover- eign debt market. If investors are in the wrong part of the sovereign debt market, they may see some signifi- cant losses.
Higher yield equities are not expensive by historic standards. Nutt says: “There are plenty of companies where the yield is supported by good cash flow and valuations are very modest.
For example, 25 years ago phar- maceutical stocks were trading on price-earnings of more than double where they are now.
“AstraZeneca now trades on 7/8x earnings. The trouble is that people are often too impatient.”
The market is increasingly rewarding companies with reliable growth, where management is show- ing good discipline in how they are using free cash flow and prioritising shareholder return rather than sim- ply looking at a high level of capital appreciation.
This includes favouring those companies that are returning cash to shareholders. The mining sector is a good example of the opposite effect – it has ploughed any excess capital back into new growth projects with declining returns, and the market does not like it.
Nutt believes that while China is slowing and banks remain reluctant to lend, parts of the equity market look vulnerable. In this climate, com- panies that offer a sustainable divi- dend with good cash flow and cover will thrive.
He adds: “We have seen good com- panies recently which have really struggled to generate funding from the banks. This is why reliability is so important at the moment. Investors tend to think in terms of an absolute income level, when really, a growing income is needed.” Nutt says the outlook for divi- dends continues to be positive. Pay- out ratios are at a low level, corporate balance sheets are relatively healthy and there are many companies with high levels of cash on their balance sheets.
Companies are in a much stronger position to withstand a profits shock than they were in 2008.
‘ ‘ Income
investors are generally investing where
profits are depressed, where the bad news is in the price, rather than buying into peak profits and peak margins
The group is discriminating in its hunt for yield. Matthews says: “High yield can be a reflection of a poor growth outlook. If a manager system- atically invests in high-yield stocks, there is a danger they may tilt the portfolio to lower growth or the struc- turally challenged part of the market. There is always a trade-off between the level of yield and a company’s prospects.
“We don’t target an absolute- return level for each individual stock because it might be that there is a restructuring story or new company management which may initially cut the dividend.
“It can be profitable to invest at an earlier stage as long as there is a rea- sonable expectation that the dividend will return.”
The companies in which Nutt and Matthews invest have strong free cash flow and dividend cover. They look at a company’s business model and whether it is built to withstand competitive forces and whether it can continue to grow under recessionary conditions.
Matthews says: “High dividend yields can be a signal that the market is negative about the cyclical outlook. “Or it may be that a company is facing a structural change. We have to analyse all these things to try and build a portfolio of companies that are offering high yields at the same time as being stable and secure.” The team is not rigid on the absolute yield of a stock and has invested in companies without a yield as long as there was a strong expectation that the dividend would materialise and grow.
Nutt concludes: “The environ- ment is tough, but investors have to ask themselves whether they would rather buy 10-year Gilts at 2% or BT at 6.5%, which had another good set of earnings figures last week. It is a resilient business. If investors can afford to be patient, they will do very well out of these businesses. “I am upbeat about UK equities in the income space. I am interested in reliable businesses that can deliver a secure and growing yield.”
Jupiter’s Anthony Nutt and Phillip Matthews, fund managers UK equities team, were interviewed by Invest editor Cherry Reynard.
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