Mark Dampier: Equity funds prepare to get defensive

The Analyst

A key issue for many investors remains the boosting of their income. This has been partly satisfied for many by holding corporate bond funds, which have come back quite strongly after a very poor 2008.

Another traditional way to get a better income is through a UK equity income fund. These too have generally had a torrid time over the last couple of years, particularly those which had large weightings in banks. Many have also been hit by falling dividends and some funds have cut their payouts by as much as 25 per cent this year.

The JO Hambro UK Equity Income Fund is a prime example. It's a fund I reviewed in May, so thought an update may be useful. It has also been hit by dividend cuts – and expects to cut its income by about 10 per cent compared to last year – but this still leaves the fund on a prospective yield of 5.8 per cent. Given where UK interest rates are at the moment, this looks particularly good. In addition, the fund has performed extremely well compared to its peers in capital terms too, so investors haven't borne the full brunt of the market falls.

The fund managers, Clive Beagles and James Lowen, have adopted a very flexible investment style and moved the portfolio quickly into the areas they felt would perform best. So far they have done a good job and the fund is among the best performers in its sector over the past 12 months.

In the early part of this year, they reduced the fund's position in defensive sectors, which they felt were too expensive, and focused more on the economically sensitive – or "cyclical" – areas. Their decision has been fully vindicated as those parts of the market rebounded strongly and the fund benefited.

The managers' current views are that the policy response of the major central banks (and indeed politicians) means we won't see a "Great Depression Mk II". The big cuts in UK interest rates have meant consumers have actually been relatively well off this year, providing they still have a job. That said 2010 could be more difficult with cuts in public spending and higher taxes on the horizon.

The underperformance of defensive sectors has meant they are now reappraising this area. However, not all defensives are the same and they believe you need to differentiate carefully between them. They pick out Vodafone, National Grid, Centrica, GlaxoSmithKline and Sainsbury's as especially promising as these are not expensively valued and have yields around 6.5 per cent.

They still believe that some of the cyclical stocks are good value, and are focused on those with low valuations and depressed profits. They are looking for companies that can come back to peak earnings in two or three years' time and have balance sheets that are strong enough to survive the current difficulty. They are nervous that government spending may be cut in the coming years, so are wary of companies that rely heavily on state contracts.

They believe there are plenty of opportunities. They cite companies such as Lamprell (specialists in oil rig repair), which has seen a strong pick up in orders, plus Legal & General and Aviva in the life sector. In commercial property, they think both British Land and Land Securities offer attractive value. Each of their holdings has to earn a place in the portfolio. In fact, it's the survival of the fittest, as Clive Beagles puts it.

Investors are getting a highly pragmatic fund, which offers a very good yield. What is more, at around £150m, it's the right size to remain flexible to the changing moods of the UK economy and stock market. This looks like a fund very much on form and should be considered for any equity income portfolio.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent