Mark Dampier: Stock market is set to continue its rise

The Analyst

I promised in my previous column I would take a look at some high yielding UK funds as I felt they offered significant value. Whilst I still feel this way, private investors should not focus too heavily on one type of fund and should aim to blend defensive funds such as Newton Higher Income (which I look at today) with more growth-orientated ones, such as Old Mutual UK Dynamic Equity and Schroder UK Alpha Plus. This will result in a more diverse portfolio.

In my view this is the best strategy given the unprecedented events we have faced and the fact that no one really knows what the next few years will look like. As I have mentioned before, I am relatively downbeat on the economic prospects for the UK, but the economy and the stock market are not the same thing. It is quite possible the stock market will continue its march upwards despite further poor economic news, largely because we remain in a sweet spot of low interest rates and upgrades to company profits, which last year were awful.

With UK interest rates at a 311-year low, it is hardly surprising that many people are seeking alternatives to holding cash. In this regard Newton Higher Income certainly commands attention with its yield of over 7%, demonstrating the ample income achievable from the UK's top blue-chip companies.

Moreover, many of these firms are likely to increase their dividends over the coming year, which makes them appear very attractive against both bonds and cash.

Although the majority of yield comes from holding shares, I should point out that the fund has also been writing covered call options on certain stocks since June 2006. This is a derivatives strategy that increases the income generated (but limits the capital growth potential for those holdings) and has enhanced the fund's income yield from just over 6% to more than 7% over the last year.

Tineke Frikkee has built an excellent track record managing the fund for nearly six years. She has a classic UK equity income style and a strict discipline of only investing in companies with a yield greater than the FTSE 350. When a share's yield falls below the average (hopefully as a result of the share price rising) she will sell it. This inherent buy low, sell high strategy is adopted by many equity income funds and a reason why they often outperform more growth-orientated funds. The trick is sorting the unfashionable companies from those in permanent decline. Tineke Frikkee has ably demonstrated this skill and has generally managed to avoid companies that have cut their dividends – not an easy task over the last 18 months.

Looking ahead, she feels there are fewer stocks likely to disappoint compared to a year ago. This has resulted in more fund ideas and her number of holdings has increased from 50 to 60.

Whilst the fund has had little exposure to banks since 2004 (clearly a good call), the strict yield discipline and defensive positioning towards utilities and pharmaceuticals companies has led to underperformance during the last year. Like many equity income funds, it has missed out on growth areas such as mining that don't yield enough to be included in her portfolio.

I believe we may well see a turnaround in performance this year as high-yielding, defensive stocks make a comeback. If not, there is an attractive income to compensate. Despite the high yield it was one of the few funds to grow its income payments in 2009, and when we last met Tineke Frikkee she thought there could be a small increase in 2010 as well.

Her feelings in many ways mirror my own: rather gloomy about the UK economy but positive on her holdings because of their international nature. With 70% of sales coming from abroad, the UK's larger companies are not reliant on a domestic recovery, so I definitely think it is worth considering this fund as part of an income portfolio.