Mark Dampier: Equity income funds must be canny

The Analyst

I have highlighted several UK equity income funds in my column over recent months. It is a sector I have always liked, partly because it is home to some very experienced managers and partly because it has served investors well over the longer-term. Sadly, some dismiss it as too boring and are instead seduced by more exciting areas. However, while chasing the latest investment fad can sometimes be successful, it more often than not disappoints.

Regular readers will be well aware of my fairly gloomy prognosis of the UK economy. An over indebted consumer and government is not a recipe for a strong economy over the next few years. Consequently, it is important for fund managers to find companies that can grow in a tough economic environment, and many equity income funds are full of just these types of businesses. A fine example is Jupiter Income run by Tony Nutt. Unfortunately, it is also a fund that has had a poor run recently, largely due to a lack of exposure to mining stocks, which Nutt sold out of a while ago. Although this was near their historic high point, and before their precipitous falls in 2008, the fund has missed out on the subsequent rally. Over the last year the market has preferred to buy the bombed out sectors (such as mining and financials) capable of rebounding the most from their lows, largely ignoring stronger, more defensive companies. As a result, the level of the stock market in the UK, and indeed in most other countries, is neither particularly expensive nor particularly cheap overall, but some sectors, and certainly some stocks, do stand out as good value.

When I met Mr Nutt recently he stressed that he is first and foremost a stock picker, and that within each sector there are companies with very different characteristics. Mr Nutt's view is that the stock market will be range bound for years to come, meaning it will make little progress upwards, but neither will it fall by much. If he is right, his emphasis on stock picking should see him outperform if he can find the right companies. It does mean, however, that investors will have to be patient to get returns. He also believes the current demand for mining stocks should be sending warning signals to investors. Commodities stocks tend to be driven by demand from China, yet this is a time when the Chinese authorities are reining in bank lending, so consumption may slow down.

So what sort of environment do we need to see for his fund to start to perform? To answer this Mr Nutt described a number of events he believes we will see: firstly, the end of quantitative easing and a gradual withdrawal of economic stimulus. Secondly, policies by governments in emerging markets to control inflation. And finally, US dollar stability, which will end the dollar "carry trade" where money is borrowed in dollars and invested in other currencies with higher interest rates. Mr Nutt believes these events will cause market volatility and weigh on more speculative assets; an environment he says will favour larger companies. It will, at the same time, be unhelpful to consumer stocks and other economically sensitive companies such as construction and real estate.

Against this backdrop the market is likely to favour good value companies paying substantial dividends. To that end, Mr Nutt holds Vodafone, Diageo, GlaxoSmithKline, BP and Centrica. He also likes AstraZeneca which has reduced its debt and yields a prospective 5.6 per cent. Given that interest rates are likely to stay low over the next couple of years I think the stage is set for a re-rating of many of these blue chip companies with generous dividends. While I remain a fan of emerging markets over the longer-term you should not write off good, old-fashioned UK income funds like this. Over long periods (for example 20 years or so) these sorts of funds are often in the top part of the performance tables.

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