For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
The answer to this may seem obvious and maybe it is, but not in the way you might think. As we have written in previous pieces, we believe there is a huge difference between running an income fund as we define it and the vast majority of income funds available in the marketplace. We understand income as the output of our fund, we seek to deliver an attractive and growing income stream over time. Many income fund managers see income as an input, they build a portfolio with stocks with attractive yields, on whatever valuation methodology they use.
For us it is the overall output to the end investor that matters. The overall portfolio needs to generate the desired income and grow that over time. We run mixed asset funds so we have to understand the interplay of our equity portfolios with our bond portfolios and the impact of that on the income stream from the whole portfolio.
Utopia
In a perfect world, we could find equities with an attractive, consistent and growing income stream that also met our macro and thematic investment criteria. These would generate capital gains over time which we could reinvest in our bond portfolio at high and attractive yields with limited volatility. All this would occur without material sell offs in either asset class, such that clients would achieve both the growing income stream and the low volatility returns they desire.
A dose of reality
Of course, this is never the case. We need to manage the aggregate portfolio construction at the same time as we manage the income. Hence, first and foremost, we are looking for stocks and bonds which suit our macro thematic process and current view on the appropriate portfolio construction. Within this framework, we then consider the income needs of the portfolio.
If our macro view suggests our equity needs to be tilted towards industries with naturally high income streams all is well. However, at many times, the more attractive sectors are in areas with limited or no dividends, whose return comes largely from capital growth. This need not be a problem; we are running an income portfolio not a portfolio of income shares. We can continuously reinvest the capital gains from these stocks into higher yielding investments, so long as our aggregate portfolio delivers the required income and growth.
Putting it into practise
Last year was a great example of this; – the top contributors to our equity total returns, were largely non-income paying stocks. Rolls Royce is a key player in the nuclear energy revival, META was a recovery situation in social media, just to give two examples. Neither pay a dividend but each fitted nicely with our macro thematic views. This isn’t a problem as our risk management approach means we repeatedly trimmed these positions as they grew, and this provided the cash that could either buy income in bonds or higher yielding equities.
At the other extreme we have a coal miner which provides metallurgical coal to the US steel industry, paying its excess cash generation as special dividends and share buybacks. This is an example of income as a sign of value, if the company can buy back 20% of its shares and pay a good dividend the chances are its undervalued.
A good recent example might be the emerging Asian markets such as South Korea. For many years most of that market has languished with poor governance, poor returns but high dividend yields. These stocks would always appear on our income screens but then fall down on our momentum discipline. Recently, for various reasons they have begun to recover and hence finally tick our momentum box and can now be bought.
Our ideal equity might have a good and growing income stream and positive momentum characteristics. These do exist, an example might be IBM, where the dividend has grown consistently over many years, on the back of strong cash flow characteristics in a growing industry. However, the market does tend to value these kinds of business very highly so it is rare to find such companies. These stocks are best bought after a period of being out of favour but, of course, with some emerging momentum.
Looking at the fundamentals
Which brings us to our key stock selection criteria, at all times we consider the evidence, fundamentals if you like; the narrative, what the markets says; and, perhaps, most critically momentum. While lowly valued stocks may abound and it may be tempting to populate the portfolio with these out of favour names, we always are looking for signs of improving momentum.
Hence, what we avoid doing is just buying income for income’s sake. High dividend yield can often be a signal of mediocre expected returns, so while from time to time you can find a high yield and good prospects, we are in no way style driven value managers. We are style agnostic; we aim to do what works in the prevailing market conditions.
These three types of income profiles can all be useful in our income portfolios: no income but strong capital returns, good and growing income, and income as a sign of value. They all have a role to play and at different stages will be emphasised differently in the overall portfolio.
At the fund level, we can look at the challenge on a holistic level. If we have a need to increase our income by 5% in a year, we have many choices. We can increase the yield on our bond portfolio by selling lower yielding assets and buying higher yielding bonds. We may have strong capital returns in low yielding equities which we can reinvest in either higher yielding equity or bonds, depending on our aggregate equity weight. Or we may have strong dividend growth in our equity portfolio to provide the desired growth. There are many ways to achieve the desired outcome at a portfolio level and we are happy to use whichever tools are working best at the time.
In conclusion, stock selection for our income funds is much the same as all our funds, we are looking for companies that meet our macro/thematic criteria with good, but ideally misunderstood, prospects but most importantly improving momentum. Where this also aligns with good income streams all is well, but otherwise as a mixed asset fund we have more than enough levers to pull at a stock and asset class level to achieve the desired level of income growth.
