The Analyst: Income funds are worth another look

It is a little over a year now since the launch of the PSigma Income Fund, which is managed by income guru Bill Mott. Nobody realised it at the time, but the launch coincided with one of the worst periods for UK high yielding shares since the late 1990s. Over the past year all the funds in the sector have made losses; it's just a question of how much.

Those with large weightings in financial stocks, and especially banks, are down the most as the credit crunch has started to bite. Those who avoided financials entirely are at the top. The difference between these two camps is broadly a loss of around 2 to 5 per cent or a loss of between 20 and 25 per cent.

Mott sits somewhere in the middle and for him, I guess, this will be a little disappointing. Given that he has had a fair amount invested in financials himself he has actually done relatively well. He has a fantastic record of investing in this sector so it is far too early to write him off.

I caught up with Mott recently in London, where I found him to be rather enjoying the challenge of investing in these markets. After all, they are the most interesting and hard to predict that we have seen for many years. He believes there are currently some echoes of both the tech problems in 2000 and the ERM debacle of 1992 – more of which later.

He believes there are three main scenarios for the short-term future of the market that seem credible. Firstly, a global recession where defensive sectors like pharmaceuticals, utilities and tobacco will thrive because they are relatively economically insensitive. He himself is slightly overweight in all these sectors except tobacco, where he is modestly underweight. Unfortunately there are not many hidden gems left.

The second scenario is the so-called "decoupling" view. This is that emerging markets will carry on doing well and offset the problems seen in the West. However, this is looking increasingly unlikely and the risk of disappointment is large if it proves to be unfounded. There are selected stocks that Mott believes represent good value, though. He holds Standard Chartered, Prudential and some of the global engineering companies that are benefiting from growth in emerging markets. One of the engineering firms is GKN, which as one of the smaller global players could well be a takeover target.

The third scenario is a realisation that domestic inflation isn't a problem in the UK; we could be seeing the start of this process now. The main things going up in price are food and fuel. The Bank of England simply cannot influence these things through interest rates, so in time they may feel like they can cut rates to start boosting the economy without fear of causing much additional inflation. Many stocks are currently being priced on the assumption that we will see a bad recession; they could bounce back strongly if the Bank of England start cutting rates. This is the view that I agree with most strongly myself.

In preparation for this third scenario taking place, Mott has taken positions in select stocks that he believes could be poised for a recovery. One is Kier Group, a construction and engineering firm that has been marked down alongside housebuilders, but has plenty of cash on its balance sheet to see it through any slowdown in business. Another favoured stock is Wolseley, which is being priced at a level that assumes business will be slow for ever – if sentiment lifts amongst investors its share price could rebound.

The PSigma Income Fund portfolio is widely spread simply because there are so many possible scenarios and outcomes. At present Mott holds 90 stocks with an underlying net yield of 4 per cent.

One of the principle reasons that income funds have generally struggled over the past year is that mining companies have risen so strongly. These firms typically pay very low dividends and as such are not an appropriate place for a true income manager to invest much of their fund. In this sense it is like the technology boom towards the end of the last century, so perhaps like then it will eventually look a blessing that income managers haven't been investing in this "hot" area.

At present the majority of private investors seem to prefer emerging markets and commodities instead of good, old-fashioned core income funds. Perhaps it is time to start redressing this balance and, in my opinion, the PSigma Income Fund would be an excellent place to begin.

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