Why invest for income?
Investors are using equity income funds as a means of gaining attractive long-term total returns, not just for the purposes of producing an income.
While the strategy is most popular with retirees, investors of all ages have a high proportion of their portfolios invested in UK income funds – an average of 26% and as high as 32% for the over 70s, an analysis of holdings on the Hargreaves Lansdown Vantage platform shows.
The stock market has been a good source of income over the last ten years, particularly when compared to cash.
Open-ended UK equity income fund managers with at least a ten-year track record have returned four times more than cash over the last decade, turning a £10,000 investment at the start of 2007 into £15,799 by the end of 2016. That compares to £11,361 for the average instant access savings account, according to the Hargreaves Lansdown UK Equity Income Report.
The UK equity income investment companies sector has fared even better, turning £10,000 into £19,255, data from the Association of Investment Companies shows. That can be attributed, at least in part, to the ability of investment trust managers to take a longer-term view, as they are not distracted by inflows and outflows, and use gearing to augment returns in rising markets.
‘If on the eve of the financial crisis you had put your money into an equity income fund, you still would have significantly outperformed cash over ten years, despite the huge falls in the market witnessed in 2008 and 2009,’ said Laith Khalaf, a senior analyst at Hargreaves Lansdown.
‘This demonstrates that while cash is the best place for short-term savings, investors squirreling their money away for the long term should make sure they have a healthy amount invested in the stock market.’
Total return strategy
Income funds come in different shapes and sizes and that is amply demonstrated by the range of returns that have been generated over the last decade. In particular, some ‘income booster’ funds have done a very good job of providing a high income, but this has been at the expense of investors’ capital.
‘This is all well and good if you are prioritising jam today over jam tomorrow, but a total return strategy is a more sustainable way of generating income over the long term,’ said Khalaf.
The power of reinvesting dividends to deliver strong total returns is exemplified in the Barclays Equity Gilt Study 2017. A stock market investment of £100 at the end of 1899 would be worth just £195 in real terms without the reinvestment of dividend income. However, with reinvestment, the portfolio would have grown to £32,050.
Ben Yearsley, a director of Shore Financial Planning, said: ‘There is a good reason why equity income funds and trusts have proved so popular with investors over many decades – simply because they are investing in cash-generating, profitable, dividend-paying companies.
‘Dividends, ultimately, are the reason you invest. It is profit, and subsequent dividends paid to the owners of a business, that drive the long-term valuation.’
Share price anchor
One of the trusts Yearsley likes is the Standard Life Investments Equity Income Trust, run on a total return basis by Thomas Moore, among the top-performing UK income managers by total return and income produced over the past decade.
He believes that cash is the best anchor in times like these, when stock price valuations are at record levels.
Dividends have also hit new peaks, with underlying UK dividend payments reaching £15.3 billion in the first three months of 2017, the highest first quarter figure on record. A year-on-year growth rate of 16.2%, fuelled by the weaker pound, helped to offset a decline in special dividends, according to the Capita UK Dividend Monitor.
‘Cash is the best anchor in this era of high valuations,’ said Moore. ‘Regardless of the latest macro noise, it is cash flow and dividend announcements at the company level that will provide the ultimate anchor for share prices.
‘As these announcements continue to beat market expectations, it is this anchor that gives me confidence in the performance of the trust in the months and years ahead.’
Stock pickers’ paradise
As the market’s focus shifts from macro to micro-level analysis, stock pickers can focus on identifying individual valuation opportunities across the market.
While there are valuation opportunities among overseas earners, Moore believes the bulk of the opportunities reside in UK domestic names, with growth in both the UK economy and corporate earnings remaining far more resilient than had been expected in the immediate aftermath of the EU referendum.
So where is he finding the most attractive stock opportunities at the moment? He looks for companies with a strong market positions, strong cash flow generation, robust balance sheets, rapid dividend growth and attractive valuations, and is finding ‘plenty’ of stocks with these characteristics.
Companies recently added to the portfolio include house builder Persimmon and home furnishings retailer Dunelm, both based in the UK, and the global mining company Glencore.
For further information, please visit our investment trust web site: www.standardlifeuksmallercompaniestrust.com
The opinions expressed are those of © Standard Life Aberdeen as of July 2017 and are subject to change at any time due to changes in market or economic conditions.
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