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The Newton Higher Income fund has been consistently one of the highest yielding UK equity income funds over the past decade with its strict focus on high yield but the last two years have done damage to its stellar long term track record in capital growth terms.
The Citywire Selection- listed fund has generated a total return of 9.09% for the three years to 21 January, compared to 14.12% for the IMA UK Equity Income sector. In capital growth terms, the numbers are less impressive still, at -21.07% compared to -9.88% for the IMA UK equity income benchmark.
On the face of it the latter numbers look pretty grisly but with a consistent historic yield close to 7% (7.14% in the year to end of June), fund manager Tineke Frikkee (pictured) has bought herself plenty of time and is comfortably top decile in terms of yield.
The £2.76 billion fund has a strict buy and sell discipline, looking to buy only high yielding stocks that generate more than 115% of the yield of the FTSE All Share and earnings are analysed on a one year forward earnings view.
Some accuse her of buying everything in her path that fits her criteria but her recent selling down of National Grid on US regulatory and debt risk is a good example of her not slavishly going purely where the high yield is.
First, lets address the reasons for the two year capital growth underperformance.
The focus on pure high yield stocks and sectors has meant Frikkee has missed out on the entire mining rally of the past two years as the sector remains one of the lowest yielders in the FTSE.
Frikkee has been zero-weighted on miners since she took on the fund in 2004, and has been underweight banks for the last three years.
To put it in context, Frikkee missed out on a mining sector that produced astonishing growth of 176% in the two years to the end of 2010.
Another key factor has been BP’s dividend suspension. Frikkee had been overweight BP at the start of 2010, and is roughly in line now. She admits that the Deepwater Horizon disaster cost her around 1% in absolute performance terms last year, although she clawed back much of the capital loss, in the second half of the year.
Frikkee will be hoping for good news when she meets the management next week, despite talk that the rekindled dividend may be a little lower than many expect.
For now her favoured bet in the sector is second largest fund holding Shell, which has underperformed its UK rival after the latter’s recovery.
For those that believe in a reversion to the mean over the longer term, Frikkee's fund may be one to keep faith with, given that low yield stocks have outperformed high yield in five out of the last six years.
Both low and high yield income sectors were off by some 40% in 2008 in capital terms, but their recovery rates have differed dramatically.
High yield underperformed low yield UK stocks by 29% in 2009 and in the two years to the end of 2010, low yield was up 76% compared to high yield stocks’ 26% in capital growth terms.
She may have made the same point a year ago, but Frikkee again stresses that high yield now look historically cheap while low yield stocks are back to roughly the valuations they were at six years ago.
Prior to the credit crunch in 2008, high yield stocks were trading on around 14 times one year earnings but that has now come down to 10 times, compared to a historic 15 year average of around 12 times.
As UK GDP is revised down in the fourth quarter, current macro uncertainty may bear her out in the months ahead as the fiscal tightening cycle in emerging markets and overheating worries act as a potential drag on commodities.
Pertinently, when Frikkee last outperformed in capital growth terms, it was during the flight to safety in 2008, when high yielding ‘steady eddies’ such as pharma became highly prized by the market. Current conditions may suit this pattern again.
Frikkee expects her capital growth fightback to come from traditional high yield areas such as pharma, as well as from selected telecoms and the oil majors, while she has been out of UK banks with the exception of HSBC for the last three years.
The pharma mega caps GlaxoSmithKline and AstraZeneca are number one and six in the fund respectively and Vodafone is number three. Frikkee believes the market will start to re-rate pharma as concerns over their pipelines of blockbusters reduce and a focus on their cash generative defensive qualities returns.
Pharma has been a huge laggard in share price terms over the last three years but Frikkee thinks the strong list of products coming through at Glaxo will eventually lead to a re-rating and a reappraisal of these stocks.
Both are below 10 year historic PE averages, not to mention throwing off 7% plus yields, and both have managed to produce steady cashflow generation throughout their relatively uninspiring share price performance and despite worries over patent cliffs and lack of block buster drugs in the pipeline.
Frikee may have underperformed the IMA equity income sector over three years but she has remained ahead of the FTSE 350 Higher Yield index over that time period, which shows she has picked better high yielders than the average manager trawling in that space.
She also has high hopes for selected telecoms stocks, which represent 9% of the fund. While she has reaped a share price rise in Vodafone over the past year, it is an anticipated re-rating at Cable & Wireless’s two divisions Worldwide and Communications that she is hopeful of.
The former, which is competing with the likes of BT for the UK corporate sector and has the Tesco UK contract is on a PE of 10 times 2011 earnings and it looks too cheap - especially when it is on a sustainable dividend yield of some 7%.
With rumours that giants such as AT&T are looking at acquiring a slice of the UK market, Frikkee thinks the group may well get bought out in the coming months and with cash generation improving in the sector, she expects to see a gradual positive re-rating of them as sustainable earnings figures come through.
She is also optimistic on water utilities this year, and has been reducing former top 10 holding National Grid on US regulatory and debt risk. Scottish & Southern, another unloved stock over the past two years and a top 10 fund holding, is a key hope for the year ahead.
Frikkee believes SSE’s investment in alternative energies is still undervalued by the market, as it trades on 11 times 2011 earnings with a yield of 6%.
Utilities remain an overweight, with Frikkee also holding Pennon, Centrica, Northumbrian and Severn Trent. With a potentially higher inflation environment further out she is optimistic they will be able to boost their earnings going forward and they have the added benefit of having already conducted their regulatory reviews.
This sector may also benefit from an increase in M&A activity if rumours that Eon is mulling selling its UK business to interested Asian investors are true.
The fund has consistently increased the income it generates to clients and advised last summer that it was on target to produce some 3% growth in the year to the end of June 2011. So far, it is on track for 4% this year.
While Frikkee is candid about her disappointment at underperforming in capital growth terms, history may be on her side.
And in a lower market return environment that many are predicting for the next two or three years at least, high yielders may just become progressively more attractive as a relatively low risk source of sustainable income.
If that comes to pass, Frikkee’s high yield focus will reap the benefit of a market re-rating, and this may just be her year.
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