Genuine income investors are making a “dangerous” mistake by buying out of favour mining and oil & gas stocks, according to Fidelity’s Michael Clark, who firmly believes their currently high yields are justified as many will be forced to cut their dividends over the coming years.
There is little doubt that mining and energy stocks have been two of the most out of favour areas of the equity market over recent years as China’s slowing growth and falling commodity prices have pushed sentiment lower and lower.
According to FE Analytics, for example, both delivered double-digit losses over the past two years while the wider UK equity market is in slight positive territory.
Performance of indices over 2yrs
Source: FE Analytics
These huge share price falls and the perceived impact these macroeconomic headwinds might have on their business models have left commodity related companies on relatively cheap valuations, though, with many mega-cap names offering yields of more than 6.5 per cent. 
Given the low-yield environment, many UK managers have been upping their exposure to these areas in an attempt to not only take advantage of cheaper valuations, but to also bolster their future income pay-outs.
Clark, manager of the £1bn Fidelity MoneyBuilder Dividend fund, says this is a very risky strategy for investors who genuinely want income.
“Where I have question marks is in the commodity sectors. I know we have seen high yields out of the mining stocks this year but I think it’s, broadly speaking, too dangerous to go there as I don’t think those yields will be honoured longer term,” Clark (pictured) said.
“We don’t have any mining in the portfolio and while we have some oil & gas, these are the safest largest names and even there we are underweight relative to the index. Going forward into 2016, I don’t propose to change that.”
The manager certainly isn’t the first to worry about the future income payments of mining and oil & gas names, with the recent Capita UK Dividend Monitor warning that the likes of Shell, BP, Rio Tinto, BHP Billiton and Anglo-American all have dividend risk.
Instead, Clark has packed his fund full of high quality, cash generative and reliable dividend-paying companies with his top 10 holdings including stocks such as Imperial Tobacco, AstraZeneca, Reckitt Benckiser and Diageo.
There is a risk to that sort of strategy, though, and it comes in the form of the price investors pay for those stocks.
These ‘bond proxy’ type stocks have performed strongly over recent years as tourist fixed income investors have flooded the market after being forced out of bonds by central bank policies such as quantitative easing and ultra-low interest rates.
The concerns are, however, that if interest rates start to rise more cyclical companies will begin to outperform from a total return point of view.
However, if investors genuinely want income, Clark says investors would be foolish to give up on them.
“You have to balance the predictability and sustainability of company that might be more expensive relative to the market with the alternatives that you have.”
Clark took two examples, multinational consumer goods company Reckitt Benckiser and Anglo-American to illustrate his point.
Performance of stocks over 5yrs
Source: FE Analytics
“Reckitt Benckiser is much more expensive than it used to be with a P/E multiple in the 20s and a dividend yield below 3 per cent, but you have a great deal of certainty that the company will grow and develop over time. I feel we can continue to hold that because it provides a decent level of dividend growth (certainly much more than the market) for the fund,” he said.
“Anglo-American and other mining, commodity and oil & gas companies may look much cheaper. They will have P/Es of single digits and very high yields, but they don’t provide any visibility of earnings and their business is very challenged by the commodity crash.”
He added: “I do recognise they are more expensive, but they aren’t too expensive and they provide the visibility I need.”
Clark’s comments are very much in keeping with his approach to the market, as he aims to deliver steady total returns with a keen eye on income growth.
According to FE Analytics, Fidelity MoneyBuilder Dividend has been a top quartile performer in the IA UK Equity Income sector since Clark took charge in July 2008 with returns of 95.17 per cent, beating the FTSE All Share by close to 40 percentage points in the process.
Performance of fund versus sector and index under Clark
Source: FE Analytics
While the manager has overseen three calendar years over underperformance over that time, they have all been strongly rising markets (2009, 2010 and 2011).
In tougher markets, though, the fund has come into its own. FE data shows it is outperforming this year, was top decile in 2014 when the index ground out a return of 1.18 per cent and was the sector’s best performer in 2011 with returns of 7.53 per cent when the European sovereign debt crisis caused the FTSE All Share to fall 3.46 per cent.
He therefore has one of the lowest maximum drawdowns in the sector.
Clark also has an enviable dividend track record as not only has his fund – which yields 4 per cent – been one of the highest-paying funds in peer group (£4,420 on an £10,000 investment made in January 2009), he has gradually grown his distributions.
Apart from his fund’s bumper pay-out in 2009, which couldn’t be sustained, Fidelity MoneyBuilder Dividend has increased its dividend in each of the last five calendar years. On top of that, with still two dividend payments to go, it looks highly likely to increase its distribution for a sixth year.
Fidelity MoneyBuilder Income’s dividend history
Source: FE Analytics *figures based on a £10,000 investment made in January 2009
All told, Square Mile says Fidelity MoneyBuilder Dividend is a worthy member of its ‘Academy of Funds’.
“Michael Clark is an experienced investor who has seen a number of market cycles over the course of his career. The stock selection process seeks to identify solid companies that have historically coped well with difficult economic conditions,” Square Mile said.
The fund has an ongoing charges figure of 0.67 per cent.
