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Yarrow: Why core equity income funds aren’t heading for a crisis

26 July 2015

Evenlode’s Hugh Yarrow tells FE Trustnet why the argument surrounding ‘bond proxies’ is very naïve and why he will maintain his high weighting to quality, cash generative companies which have served him so well.

By Alex Paget,

News Editor, FE Trustnet

The concerns about high quality cash generative mega-cap equities (which have been dubbed ‘bond proxies’) has been blown out of all proportion, according to Hugh Yarrow, who says genuine income investors shouldn’t be concerned about short-term share price volatility in the search for strong long-term dividend growth.  

Thanks to years of ultra-low interest rates, quantitative easing (QE) from the world’s central banks and a global deleveraging cycle, bonds have delivered phenomenal returns to investors since the global financial crisis.

However, this added liquidity has benefitted areas of the equity market as well, as ‘tourist’ fixed income investors have been forced out of lower risk assets into dividend paying stocks for yield.

This trend has meant high quality companies with reliable dividends (such as those in the consumer goods sector) have performed phenomenally well since the financial crisis, which has helped core equity funds such as CF Lindsell Train UK Equity and Fundsmith Equity to massively outperform their peers.

Performance of indices over 5yrs

 

Source: FE Analytics

However, with the potential for rising interest rates in both the UK and US, many warn that these stocks will suffer as yields on bonds and cash become more attractive – such as the team at Ruffer who recently warned that UK equity income funds could be heading for a crisis.

Yarrow is one of the most exposed to such an event as he counts the likes of Unilever, Diageo, Imperial Tobacco, Johnson & Johnson, Procter & Gamble and Reckitt Benckiser featuring in his five crown-rated Evenlode Income fund’s top 20 holdings.

While he understands why many warn over the outlook for large-cap consumer goods companies, he has no plans to change his positioning.

“There has been quite a lot of talk about bond proxies over the last year or so, so I thought I’d address the issue upfront,” Yarrow (pictured) said. “Bond yields are very low and are very low relative to history. From being very low, they have gone even lower and we are in almost in unprecedented territory here.”

“I wouldn’t argue with the contention that the current interest rate environment and level of bond yields has had an effect on equity valuations and I would point to certain stocks in the market which were on much higher yields five or six years ago than they are today.”

Many, such as FE Alpha Manager Alex Wright, have warned that the outlook for consumer goods companies is now tightly correlated to the fortunes of government bonds which, as the graph below shows, seems to have been the case over recent months as US treasury yields have risen.

Performance of indices since April 2015

 

Source: FE Analytics

“While these stocks have been historically viewed as safe, in a bond sell off – which may or may not happen – I don’t think they would be particularly safe and therefore I am very much staying away. They have limited upside because of their high valuation and actually offer quite large downside,” Wright said.


 

However, Yarrow says investors shouldn’t be too quick to generalise.

“That’s the market on aggregate, though, as you can be selective. You can still construct a portfolio that has a nice starting yield and has nice potential for dividend growth. For instance, I find it reassuring that our portfolio yields 3.75 per cent (which is still very much within its historic range) and there has been dividend growth.”

Certainly, Yarrow has achieved his aim of delivering a growing source of income. Not only has the fund paid out £3,138.64 in income on a £10,000 investment made at launch in October 2009, it has increased its dividend in every year over that time.

 

Source: FE Analytics/Evenlode Income

Yarrow added: “This leads me onto my second point. Bond’s don’t increase their distributions, good quality equities do. They also have pricing power so have the ability to hedge against inflation.”

He says, therefore, that genuine income investors shouldn’t be caught up about potential short-term price volatility with high quality dividend paying equities.

“Clearly, equities are a more volatile asset class and anyone investing in equities needs to have a time horizon of at least three years, but ideally more than five. You need to be prepared for volatility but if you have the patience to cope with wobbles in share prices in the short-term, you can find some good companies with good potential.”

“Looking ahead, and assuming we are not off to the races again and assuming the economy remains quite tough, my view is that these types of stocks should be able to grow their dividends by mid to high single digits.”

Of course, the manager’s 33 per cent weighting to consumer goods (which has remained relatively constant since launch) has helped his performance. Evenlode Income, for example, has been a top decile performer in the IA UK Equity Income sector since inception and has beaten the FTSE All Share by more than 30 percentage points in the process.

Performance of fund versus sector and index since launch

 

Source: FE Analytics

What’s more, the fund has outperformed both the sector and index in four out of the last five calendar years, the exception being the rising market of 2012 when it still returned 11.96 per cent which meant it underperformed the FTSE All Share by 0.34 percentage points.


 

While Yarrow admits that a rate rise could cause heightened volatility within high quality, dividend paying equities, he says he is looking at longer term gains and income generation and so sees little point in changing his portfolio now.  

“My view is there is already negative sentiment surrounding these stocks. I’m not saying there won’t be volatility, but take Unilever which yields approximately 3 per cent.”

“It has delivered long-term dividend growth of mid to high single digits, increased its earnings by 10 per cent and 11 per cent over the last two years (has actually been a bit lower after currency movements) and has recently increased its dividend by 6 per cent.” 

“Now, when I look ahead over the next five to 10 years, it should be able to continue that dividend growth. Yes, you could have bought Unilever at a much lower yield in 2009, but there is an opportunity there with a yield of 3 per cent and dividend growth of 6 per cent.”

He added: “The point is, when you sell a top-quality company like Unilever, you need to find something else to buy instead.” 

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