Henderson (pictured) says that good-quality companies with a high dividend yield are now often too expensive to offer value, and there is little prospect of growth from these areas in the future.
Investors are better off looking to smaller companies or more cyclical sectors for their equity income exposure, he says.
“The discipline of selling the lower yielding shares and buying the higher yielding shares works when the higher yielding shares have been dismissed by investors as boring or too cyclical,” he said. “But this is not the case at the moment.”
“Given low interest rates, there has been a concentrated effort by fund managers to find good high-dividend companies.”
“The space is in danger of becoming overcrowded. In this rush, the exciting smaller company has until recently been more neglected.”
“The best chance the investment manager has of adding value is to pay attention to areas others are not, hence the smaller company area has proved fruitful.”
The challenge for investors looking to rotate out of the highest-yielding sector is to maintain a decent level of yield at the same time.
Henderson’s open-ended Henderson UK Equity Income fund was recently booted out of the IMA Equity Income sector for failing to keep up with the required yield target of 115 per cent of the yield of the FTSE.
The fund is yielding 3.3 per cent while the Lowland trust is yielding just 2.32 per cent.
“Although the dividend has risen 11.5 per cent this year, the yield of the portfolio relative to the index has fallen as the capital outperformance has outstripped the income growth,” he said.
Unfortunately, many of those funds that focus on the lower cap areas of the market are also struggling to provide a high yield.
Unicorn UK Income has been one of the most popular funds of the last six months, thanks to its outstanding track record.
It has made 77.63 per cent over three years while the sector has made 36.32 per cent.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
However, it is yielding just 2.89 per cent, according to data from FE Analytics, the second-worst figure of the 91 funds in the sector.
Henderson is also looking to more cyclical areas of the market with greater growth prospects, warning that investors who buy the highest-yielding funds are often locking themselves in to areas with little prospects for upside.
“The problem for the income-focused fund manager is that currently some of the better growth opportunities reside among the lower-yielding shares,” he said.
Lowland has 27.89 per cent in industrials, his biggest sector bet, with engineering firms Senior and Carclo the two largest positions.
He says that he has no plans to sell out of his punchy growth stocks into higher-yielders, as he won’t buy weak companies simply for a dividend.
“We will keep looking for opportunities, but it has been important to retain shares that are making good operational progress and not be tempted to sell prematurely,” he said.
“Good companies selling excellent products that are genuinely competitive are benefiting from the growing global economy.”
“The products need to have an edge – usually associated with technology or a service – that makes them better than others.”
“There is no place for ‘me too’ type products and companies. Therefore it would be wrong to rotate the portfolio from the strong to weaker companies on valuation arguments unless the weak company is going to radically change.”
“For the income-orientated investor, it has never been easier to fall into a value trap. For instance, the weighting in the utility sector is very low.”
“The regulatory and pricing environment will only get increasingly difficult for many of these companies and they are often trading above their regulatory asset value.”
“The industrial companies we own have greater control over their destiny. If they remain focused and competitive, they will continue to prosper.”
The Lowland IT has returned 42.78 per cent over the past 12 months while the FTSE All Share has made 16.98 per cent. The average Growth & Income trust has made 26.8 per cent.
Performance of trust vs sector and index over 1yr
Source: FE Analytics
The track record is even more impressive over the longer term: over five years it has made 277.8 per cent against the 85.71 per cent of the index.
Performance of trust vs sector and index over 5yrs
Source: FE Analytics
The trust has ongoing charges of 0.9 per cent inclusive of a performance fee.
