“Have equity income funds had their day?” You might imagine this question – posed last month by this Financial Times article – is not one equity income fund managers such as ourselves would wish to see highlighted.
However we are nothing if not contrarian here on The Value Perspective and our short answer would be: “That would depend on how the equity income fund is constructed.”
Our somewhat longer answer would begin by noting the dangerous fixation many investors now have – to the exclusion of any other measure of a business’s financial health – with the dividends that companies pay out to their shareholders.
High yield used to mean undervalued
After all, there was a time – and it was really not that long ago – that a high dividend yield was suggestive of an underappreciated and thus undervalued business.
In the environment of low interest rates that has persisted since the depths of the financial crisis in 2009, however, it is the companies offering the highest dividend yields that now tend to be most in-demand from investors.
These have thus grown to look very expensive when assessed on traditional valuation metrics, such as their price/earnings ratio.
In effect the market’s obsession with yield has served to turn once solid and stable stocks into momentum bets – in the process raising the question of how long some businesses can maintain their dividends without impairing their intrinsic value.
As a result, we share many of the concerns raised in the FT article – for example, the way some of the UK’s biggest business are stretching their balance sheets by paying out high dividends in a bid to remain in the market’s good books.
The FT quoted a study by AJ Bell that suggested dividend cover for FTSE 100 companies was less than 1.5 times while, for the country’s top 10 dividend payers, it was just 1.17 times.
“That makes them very fragile indeed,” the article went on. “If you are covered 12 times, some really dreadful things have got to happen to your business for you to have to cut your dividend. If you are only covered 1.17 times, one mildly difficult thing will do it.”
Half of FTSE 100 dividends from 7 stocks
Worse still, it added, half of all FTSE 100 dividends paid out this year were forecast to come from just seven stocks – so what happens if one or more of them were to crash?
We are hardly in the realms of speculation here.
After all, the dividend offered by Provident Financial has for years made it a key holding for equity income funds – right up to the moment this August when the sub-prime lender had to cut its dividend and saw its share price fall two-thirds in a single day.
“This is, of course, the key problem with income obsession,” noted the FT. “Overreach and you can pay with your capital.”
That strikes a real chord with us because, when we think about the yield on our own equity income funds, minimising risk is uppermost in our mind – indeed, it is a crucial part of our whole investment process.
A strong balance sheet is essential
To be specific, we define risk as the permanent loss of capital and the best way of guarding against this, we would argue, is to ensure the businesses we invest in have strong balance sheets.
Only if we are satisfied its balance sheet is in good shape will we look at a company’s earnings, adjusted to take account of cyclical influences – and of course we will then consider the valuation of those earnings.
In doing so, we are able to unearth businesses that can demonstrate sustainable income trends rather than reaching for stocks with the very highest yields that could risk significant amounts of our clients’ capital.
Over time, this approach should generate a yield that is greater than the benchmark index and, crucially, a larger pot of capital from which to earn a cash dividend stream.
Yes, the fund’s headline yield will fluctuate according to market dynamics and the equity valuations on offer and yet it is our strong view that targeting an arbitrary fund yield, irrespective of the prevailing investment environment, is not in our clients’ best interests.
As a postscript, regular visitors to The Value Perspective will be aware we have recently built up a holding of our own in Provident Financial. You can read our reasoning here but we would also draw your attention to our article Extreme medicine, written back in 2013, where we discussed how businesses that had taken the tough decision to cut their dividends after the financial crisis had in time been able to bounce back more strongly.