Advice for stock-pickers: buy what the market wants to sell

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The Independent Online
Schroder Income Fund, Schroder's first unit trust, founded in 1968, is all UK and all equity. Its investment objective is to invest in shares that will increase its dividend income faster than the average dividend growth of the main UK equity market indices.

While the yield on the fund, presently at 5.1 per cent, is not high compared with fixed-interest securities such as corporate bonds, the potential long-term return is much greater than a bond fund because share prices tend to outperform bond prices. Meanwhile, it is well above the current average yield of 3.97 per cent on the top 100 shares and the 3.82 per cent average on the All-share index.

The narrow parameters make the fund sound a bit dull - no exotic Eastern markets, no whizzy financial instruments, no racy recovery stocks - but its disciplined approach is the key to consistency, according to its manager, Chris Rodgers.

"We do not slavishly go for high-yielding stocks as that is a cul-de- sac for performance," he says. The skill comes in filtering out the dross.

High yields can indicate that the market is overly cautious in rating the stock or can signal that the market thinks there is something unsafe about the company's future or takes a gloomy view of future profits growth.

"You have to respect the market," Mr Rodgers notes, while taking advantage of its imperfections. Now, he says, is a good time to buy high-yielding stocks, because there are some genuinely underrated companies on offer.

According to the Schroder house view - the guiding principle in Schroder investment decisions - the market has got it wrong. In the past few months the market has shunned income stocks and bought growth companies. It has chased consumer stocks in the expectation of Budget tax cuts but sold industrial stocks as UK economic growth slows.

Schroder believes the slowdown is just a mid-cycle stock adjustment and expects growth to resume at 2.5 per cent to 3 per cent next year.

The income fund is therefore underweight in consumer goods and service sectors and overweight in industrial sectors, like engineering, where companies are boosting exports on the back of a weak pound.

British Steel is a classic example of an income fund play, Mr Rodgers points out. It price-earnings multiple this financial year is less than five and its prospective yield is 6.8 per cent against an average for the market of 3.8 per cent.

The rating is derisory as the company is not looking over a precipice, but is typical of a cyclical stock at the peak of the cycle, he says.

The discipline in stock-picking is to select sensibly. "You beat the market by buying things in the short term that the market wants to sell," Mr Rodgers explains.

The implicitly contrarian approach leads in the long term to outperformance. "The total return on income-driven investment has historically beaten the market," Mr Rodgers claims.

The trigger for selling is usually when the yield drops below the market average, although the income fund does not rigidly follow this rule. It holds stocks for an average of three years and limits its range to a total of 90 companies. At present it holds 75 companies with 8 per cent in convertibles, bought as a cheap way into equity.

The strict formula of the income fund limits the prospect of picking spectacular winners or losers. However, Mr Rodgers points to Glaxo as an example of best practice.

The fund started buying Glaxo when drug stocks were out of favour due to worries over President Bill Clinton's health-care reforms and fears of a squeeze on margins from sales of generic drugs.

Glaxo suffered additionally from jitters over the expiry of its Zantac patent. Schroder started buying when the shares were below pounds 6 and the yield 5.5 per cent.

The shares are now nudging pounds 9 and they yield 4.2 per cent. Glaxo Wellcome, as it is now, remains the fund's fourth-largest holding.

Timing is the key. Where Schroder gets it "wrong", Mr Rodgers says, is if it looks too far ahead when the market is preoccupied with short-term issues.

The income fund's overweight stance in property has proved a disappointment so far as recovery in rental growth has not come through as fast as expected.

However, vacant space is falling and property shares display wide discounts to net asset value and above-average yields.

The house policy is a fundamental, top-down view of the UK economy that prescribes which sectors are in and which are out.

Sector specialist analysts and fund managers, who divide into three stock teams looking at large, medium and small UK companies, then do the bottom- up stock picking.

For the medium to smaller companies the approach is "menu-driven" and fund managers select from a Schroder-approved list of up to 200 stocks.

Schroder is presently keen on financial companies because of their modest valuations and sensitivity to improving interest rate expectations. The income fund has almost 30 per cent of its assets in financials against their weighting in the FTA All-share index of 17.5 per cent.

Life insurance companies are the hottest favourites, with a weighting in the fund of 7.6 per cent against 1.9 per cent in the All-share. All the bad news on pensions mis-selling and sluggish sales growth is in the price, Mr Rodgers says.

The fund is also slightly overweight in medium to small companies in the belief that as long as the economy continues to grow they should perform well.

With new money continuing to flow in - the fund now has pounds 230m under management - new buy ideas can be incorporated without the cost of selling the old.

Good yields on the leading stocks mean there is plenty of potential value to go for.

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