Although markets have been volatile over the last few weeks, it was the "safer" dividend-paying companies that led the equity rally at the beginning of the year. Many commentators are worried that the re-rating has made these stocks too expensive, and have upped their exposure to more economically sensitive stocks as a result.
Nevertheless Smith, who co-manages the five crown-rated Bedlam Global Income fund, says that while the macroeconomic environment remains uncertain, income investors should not ignore the so-called "expensive defensives".
"Some of the defensive stocks may now have a high P/E [price/earnings] ratio, but that is no indicator of a company’s value," she said.
"What you want to know is what a company’s growth prospects are."
"Yes, if economic growth picks up, the earnings of those [defensive] companies may look pedestrian in comparison to other more cyclical areas of the market. For instance, an automobile company will do well if there is a pick-up in demand."
"However, while there is still uncertainty in the global economy, you want to be investing in companies that have a predictability of cash-flow."
"Some parts of the dividend-paying market are overstretched, but in aggregate there is no bubble appearing in dividend-producing stocks, so it makes sense to us to focus on good-quality companies with free cash-flow," she added.
JOHCM’s Alex Savvides rejects this view, insisting that the recent sell-off in defensives suggests there is a big shift taking place in market sentiment.
However Rob Jukes, global strategist at Canaccord Genuity Wealth Management, is on the same page as Smith. He says that defensive dividend-payers will remain popular because there is little growth in the economy and bond yields will remain low for the foreseeable future.
"Cyclical stocks started to underperform defensives in 2011. So is it time for a sector rotation into underperforming cyclical stocks? We doubt it," he said.
"While that may seem strange at first, the absence of growth drivers makes clear the dynamic of portfolio flows out of fixed income, chasing yield up the risk curve into equities. Higher-yielding expensive defensives, with the perception of safety, have been the clear beneficiaries."
"Without much higher bond yields or more economic growth – the usual catalyst for cyclical outperformance – we struggle to see the drivers for a significant sector rotation."
"So, if we are right, and defensive yield-plays continue to outperform, the recent market correction may be an opportunity to look again at some of those – now not so expensive – dividend payers," he added.
Smith has managed the £12m Bedlam Global Income fund since June 2007 and was joined by co-manager Richard Greenwood in October 2008.
With Smith at the helm, Bedlam Global Income has been one of the top-performing funds in the IMA Global Equity Income sector and has beaten its benchmark – the MSCI AC World index – over one, three and five years.
The fund has returned 40.18 per cent over three years, making it the fourth best performer in the sector over this time.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
Bedlam Global Income currently has an attractive yield of 4.9 per cent. As FE Trustnet recently highlighted, the fund has not only been one of the best performers in the global sector over the period, but also has a very low correlation to the UK market.
Smith says the uncorrelated outperformance has stemmed from having an unconstrained mandate along with a strict focus on dividend-paying companies with high free cash generation and capital discipline.
She runs a portfolio that typically consists of 30 to 50 "best-pick" holdings. Smith only invests in companies that have a minimum historic dividend yield of 2.5 per cent.
"This is a very easy screening process and it cuts the investable universe – which is more than 15,000 companies – by around 40 per cent," she said.
From there, Smith and the rest of the team refine that search by finding companies with rising earnings and free cash-flow, which means they each bring in their economic views and analysis of the credit cycle.
The next step is to identify the companies' earnings drivers to make sure they are repeatable.
Smith says there is a real emphasis on cash-flow because it is the "most difficult figure to manipulate" on a company’s balance sheet. When looking at a cyclical stock, however, she does things a little differently.
"When we look at cyclical companies, we tend to focus on earnings as to whether we want to hold it, because with those businesses, the cash-flow always seems to look great at the wrong times," she said.
In order to make sure the fund does not become over-concentrated in one area, Smith implements a number of risk controls. These include a restriction on the maximum weighting the fund can have to any given region, sector or market cap.
"With those individual country limits, it means I cannot fall in love with any one country. So although I like the Nordics and they throw up a lot of opportunities, we can never be overly exposed to those countries," Smith said.
The team sets a target price for each of its holdings in order to secure gains and to minimise losses, however Smith says they never really take a view on a company that is longer than three years.
"We don’t look at a company’s prospects past two or three years and that is because the management team cannot tell you what will happen. We may look longer if the management team have a set target, however," she added.
Bedlam Global Income requires a minimum investment of £3,000 and has a total expense ratio (TER) of 1.31 per cent.
