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Beware equity income bubble, warns Ruffer

08 August 2012

The same team that called the 2008 financial crisis and QE-fuelled rally in 2009 believe increasingly popular income stocks and funds could be at significant risk.

By Joshua Ausden,

News Editor

There is a bubble forming in the hugely popular equity income sector, according to FE Alpha Manager Steve Russell (pictured), who believes the vast amount of money flooding into stocks like Vodafone is unsustainable. 

The market turbulence of the last five years has seen a significant flight to safety. While some believe the worst of the eurozone is over and have upped their expoALT_TAGsure to riskier assets as a result, Russell believes the current high inflation and low interest rate environment will become more extreme, pushing more and more money into defensive income-paying stocks. 

“It has all the characteristics of a bubble, in that there are vast amounts of money flowing into companies that are already on high price to earnings ratios,” he said in an exclusive interview with FE Trustnet.

“We’re not at the bubble stage yet, but you can guarantee that there is always going to be a problem when this much money is going into one asset class.”

“The risk of there being negative nominal interest rates is very real. If this were to happen, this would only exacerbate the flight to safety.”

Speaking to FE Trustnet last week, the manager of the FE five-crown rated CF Ruffer Total Return fund said governments would resort to money-printing to burn off high debt levels, which could lead to inflation as high as 9 per cent in the UK.

“When savers see the real value of their cash diminishing, these stocks look very appealing,” he explained. “A company like Johnson & Johnson, which is yielding 3.5 per cent on a price to earnings [p/e] ratio of 17, looks decent value, but if the yield goes down to 2 per cent and the p/e up to 25 times, you have a problem.”

“This isn’t to say that you shouldn’t ride the bubble, because there is clearly a strong case for equity income. However, it’s definitely something we’re keeping an eye on.”

Russell points to “safe-haven” stock Vodafone as an example of a company that could be susceptible to a correction.

He commented: “I suppose you could say this is quite safe, but it’s not without its risks. Yes it’s globally diversified, but this also means it has exposure to the biggest problem countries, in both the emerging and developed world. It has and will continue to have problems in Italy and Spain.”

“Any company can be perceived as safe, but you can’t see the future. There is huge stock specific risk in the asset class, which we saw in 2010 with BP.” 

“We hold Vodafone, but not as much as we have done in the past.”

Russell’s CF Ruffer Total Return fund – which he manages alongside fellow FE Alpha Manager David Ballance – was initially launched as an income fund back in September 2000. However, Ruffer decided to change the strategy even before they were wary of a bubble forming.

“We found there’s a conflict between producing an income and an absolute return, because having an income target limits your investment universe,” he explained. “None of our funds have benchmarks, but having to hit a 3 or 4 per cent yield acts as a type of benchmark.”

Performance of fund versus sector over 5yrs

Source: FE Analytics

According to FE data, the fund has returned 58.09 per cent over five years – the highest of any fund across all four multi-asset sectors in the IMA universe. It performed particularly well in 2008, when it managed to deliver more than 20.88 per cent compared to its sector’s -15.84 per cent. The portfolio has a yield of 2.71 per cent.
FE Alpha Manager Francis Brooke, who heads up the five-crown rated Trojan Income fund, agrees that there is a possibility of a bubble forming in the asset class; however, he says certain sectors still hold plenty of value.

“This is something we’re monitoring quite closely because certain areas do look expensive,” he said. “I wouldn’t recommend investors adding positions in Tobacco or in some of the food companies like Unilever, for example. We own a lot of these companies, but I’d say they’re fair value now.”

“That said, there are certain sectors that are very cheap, like pharmaceuticals and energy.”

“It’s something worth keeping an eye on, but there are still a lot of quality companies out there on single p/e ratios.” 

Russell also points to a bubble in Apple, which he doesn’t own across any of his portfolios.

“Of course there’s a bubble in Apple,” he said. “No one company can continue being that profitable and dominant in a single area.”

“When you hear projections of the company accounting for 2/3 of GDP in 10 years, you’re getting into dot com territory.”

“However, it’s a fantastic company and I wish I’d spotted it all those years ago. Like all bubbles, interest is based on sensible, logical judgements. But nothing lasts forever.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.