Invest like Neil Woodford: the art of turning a good income

Danielle Levy reports on the hunt for companies that distribute healthy dividends

Neil Woodford was the doyen of UK fund managers seemingly able to achieve both investment and income growth

The shock departure of star fund manager Neil Woodford from Invesco Perpetual has left many investors in a daze. He was the doyen of UK fund managers seemingly able to achieve both investment and income growth.

But with Mr Woodford now gone, what next for Britain's army of small investors? Can they learn from him perhaps and start practising the art of income investing for themselves?

On paper, investing for income looks fairly straightforward. It involves targeting companies that pay out regular dividends to reward their shareholders and demonstrates capital discipline. Getting the balance right between selecting companies that can pay out a healthy dividend alongside those with the potential to grow their dividends is essential. Likewise, steering clear of stocks with the potential for profit warnings or declining earnings is another must, as both can lead to dividend cuts and share-price falls.

In spite of the challenges, investors who back the right income stocks can be rewarded handsomely. By investing with this bias you are able to benefit from the compounding effect of reinvesting the returns made on your underlying portfolio, maximising the potential to boost gains even further. You are effectively being paid to wait for the value of your underlying investments to rise. If you had invested £1,000 in Mr Woodford's Invesco Perpetual High Income fund at launch in 1988, you would now be sitting on £22,919.51. A similar amount invested in the FTSE All Share would be worth just £10,254.66.

A quick scan of Mr Woodford's top 10 holdings includes mostly household names such as AstraZeneca and GlaxoSmithKline, British American Tobacco and Imperial Tobacco, alongside BAE Systems. On average these companies appear in 60 per cent (often more) of UK equity-income funds, according to data provider Lipper.

So is constructing your own portfolio as easy as just including such big blue-chip names? Not quite. Thomas Moore, a fund manager at Standard Life, says this tactic does have some merit but as the economy improves he says it is wise to "look beyond these most-established income names". He adds that it makes sense to back companies which can really benefit from economic recovery and have the potential to grow earnings, as this can later translate into increased dividend payouts.

He cites BT as one of the few FTSE 100 stocks that fits this bill. The group's management team have largely turned around its prospects. And following a large-scale, cost-cutting exercise and restructure, BT is now investing for growth across areas like TV, with BT Sport, and mobile. He also highlights dividend growth of 10-15 per cent and a 4 per cent dividend yield, which indicates how much the company pays out each year relative to its share price.

"This is an exception with the FTSE mega-cap stocks. There aren't many with the characteristics of BT with bolted-on growth over the next few years," says Mr Moore.

Martin Turner, manager of the Miton UK Multi Cap Income fund, agrees there are very few large caps that have been completely overlooked by investors, with supermarket chain Sainsbury featuring among this minority.

"Sainsbury is forecast to yield 4.4 per cent this year and has asset backing from store ownership. It has traded well and grown the dividend 5 per cent per annum in the last three years despite the consumer environment," says Mr Turner.

For Stephen Bailey and Jan Luthman, who co-manage the Liontrust Macro Equity Income fund, spotting the potential losers is just as important as identifying the winners.

It is for this reason that they have sold holdings in household brands like Unilever and Reckitt Benckiser, where they feel that higher stock-market valuations may not prove justified if earnings growth slows.

Likewise they have concerns about tobacco and energy companies, given the headwinds they face from politicians and consumers alike.

"Things like Ed Miliband's attack on energy firms highlights the political risk with these things. It shows the wisdom of looking not just at the dividend, but also the nature of the business, its ability to grow and what risks are attached to that business model," Mr Luthman says.

Mr Moore, on the other hand, cites AstraZeneca as a large cap to avoid as he expects it will face declining revenues in coming years which could put pressure on dividends. This could be caused by a number of drug products coming off patent, alongside cut backs in government health spending around the world.

So if these are the areas to avoid, where are the opportunities? He views EasyJet as a stock that can easily get overlooked, but shouldn't do. It offers an attractive and growing dividend stream, with cumulative yield of 15 per cent since the start of last year.

"It is a stock that income investors would have been spurned back in 2011 and 2012, but it has provided massive dividend growth. People should not be put off by low starting dividend yields," he says.

In Mr Turner's opinion, income opportunities are prevalent in the smaller company space for those willing to take on more risk and potentially less liquidity in their portfolio.

At the small-cap end of the market Mr Bailey says the Harry Potter publisher Bloomsbury is one to watch, as it diversifies its business model and moves into the professional-journal market. "It has transformed itself from the days of making money from Harry Potter. It has a yield in excess of 4 per cent and has stated its intention to increase the dividend," he explains.

For those who prefer to leave the stock picking to a professional, what are the options? Brian Dennehy, managing director of FundExpert views the Rathbone Income fund as a top pick for investors seeking exposure to small and medium-sized companies. It has a yield of 3.6 per cent.

For those who want access to more domestically focused stocks that can benefit from the recovery, he also highlights the Schroder Income fund, which yields around 3.3 per cent.

Danielle Levy is a reporter at citywire.co.uk