While economic growth is generally considered to be positive for equity investments, the recent sell-off in markets was attributed to a sense that rising economic growth and inflation may cause interest rates to increase at a faster rate than previously expected, particularly in the US. 
FE Alpha Manager Hugh Yarrow (pictured) of the Evenlode Income fund said there is no perfect way of insulating your investments from an environment in which both inflation and interest rates are rising: particularly if the rise were to be rapid.
However, he said there are four qualities he looks for in stocks that can provide an important safety buffer to such a scenario: a strong balance sheet, market-leading competitive position, asset-light business model and high free cash-flow yield.
“Whether interest rates in the developed world do rise by any significant degree in the next few years remains to be seen,” said the manager.
“Various structural deflationary factors are unlikely to dissipate in the medium term, including a high stock of global debt (for which even a small rise in rates may create problems and tip the world into a deflationary environment), demographic trends and innovation.
“And either way, companies benefiting from the above four factors should remain good friends to shareholders,” Yarrow continued.
“They equip a business well to produce an attractive, inflation-protected free cash-flow stream through a wide range of economic conditions – the Holy Grail for long-term dividend growth investors.”
In the past couple of weeks, the FE Alpha Manager has begun to “gently nudge” his portfolio towards holdings where he sees the best combination of quality and free cash-flow appeal.
While this has been stock specific – he added to his position in Moneysupermarket, for example, after shares fell following results last week – he said a broader trend worth highlighting is that several of the more consistent, stable franchises in the portfolio have seen their share prices fall over recent weeks, in some cases by quite a lot.
“We have begun to gently ‘nudge up’ some of these positions for the first time in a while,” the Evenlode Income manager explained.
“Examples include Unilever, Sage, Pepsi, Johnson and Johnson, Smith & Nephew and Reckitt Benckiser.
“All of these companies are trading on attractive free cashflow yields that very comfortably cover current dividend payments. Moreover, they possess many of the most important characteristics for delivering real free cashflow growth over time through a wide range of economic conditions.”
Yarrow said Pepsi is a good example of a company that exhibits at least three of the four inflation-protection qualities he looks for, putting it in a good place to defend against a competitive environment and disruptive trends – or “The Amazon Effect”.
“Investment, agility, innovation, brand strength, scale and regional diversification are all important factors,” the manager continued.
“In Pepsi’s case these characteristics have allowed the company to grow sales and earnings at a decent clip (4 per cent and 9 per cent per annum respectively over the last five years) despite these headwinds having been in place for some time. The company also announced a 15 per cent dividend increase for 2018, its 46th consecutive annual dividend increase.”
Another example of a “consistent, stable franchise” in the portfolio that Yarrow has added to in recent weeks is Relx, which he said tied into another theme he is keen to tap into – digital franchises with deeply embedded customers and recurring cashflows.
“For those companies best placed to harness the biggest trends in the business world today – efficiency, big data, software analytics, machine learning and so on – opportunities continue to abound,” he said.
“Relx is as well placed as any in this regard, using information and analytics to help its customers make better decisions, and therefore also help improve its efficiency and product quality.
“The evolution of Relx’s product offering should not just drive growth opportunities. It should also augment the level of customer ‘stickiness’ given the embeddedness that comes with these increasingly sophisticated decision analytics tools.”
Performance of fund vs sector & index since launch
Source: FE Analytics
Data from FE Analytics shows that Evenlode Income has made 180.62 per cent since launch in October 2009, compared with gains of 112.37 per cent from its IA UK All Companies sector and 107.25 per cent from the FTSE All Share. It has beaten the index in every full calendar year since opening for business.
The fund is yielding 3.3 per cent. Anyone who invested a £10,000 lump sum into it at launch would have received £4,477.91 in income alone over this time.
Evenlode Income has an ongoing charges figure (OCF) of 0.9 per cent.