Mark Dampier: Don't underestimate the importance of income

The Analyst

Unquestionably the most popular asset class with investors recently has been bonds. It has been this way for some time, particularly in the United States. Often I think popularity is a warning sign. The more people who buy into an area the more fashionable it becomes and this can lead to overpricing. Yet with many expecting interest rates to remain low, on this occasion I think the popularity could be warranted, at least for the time being. Government bonds have been in a bull market since 1990 when UK interest rates were 15 per cent, and this long-term trend could have a little further to run. However, the longer it does the more risk there is, and even now a contrarian investor would probably look to other asset classes for returns, notably equities.

True, equities have generally failed to perform over the last decade – perhaps largely because they were overvalued 10 years ago. I feel this is far from the case today, and one area I remain a particular fan of is UK equity income. These funds have been through a challenging period over the last couple of years given the nature of the recession we have had, though looking at Newton Higher Income over 15 years I note that the annualised return has been 9.4 per cent against a sector average of 6.9 per cent and the FTSE All Share index of 6.4 per cent.

So despite a difficult time, Newton Higher Income has given a pretty good total return. In fact, this is often true of high yield equities generally against their lower yielding counterparts. Total returns for high yield are some 10.8 per cent per year against 7.7 per cent for the low yield index and 9.2 per cent for the market. And that is for a genuinely long period – over 100 years! However, for some reason investors tend to underestimate the importance of dividends and prefer to focus on the latest growth story. That doesn't mean high yield stocks don't have their difficulties, though. Like most equity income funds Newton Higher Income has suffered from BP's dividend cut this year.

What manager Tineke Frikkee didn't expect was the previously declared dividend to be cancelled too, meaning three dividend misses in all. As a consequence the benchmark yield on the FTSE dropped to 3.2 per cent, which actually enabled her to add new names to the portfolio. Newton look at the benchmark yield on the index and only invest in shares trading at a premium to it. So, with the index yield dropping she was able to buy Tesco, HSBC and Next, each of which Newton's analysts rate highly. This fund adopts a classic equity income technique; buying shares on a high yield and then selling them once they become more fashionable and the yield drops below that of the benchmark.

Effectively there is an enforced discipline in buying low and selling high. The loss of dividend from BP has meant a cut in payouts from many equity income funds. However, Tineke has more than made up for it elsewhere with income from other stocks. In fact, she anticipates increasing the fund's income by a small margin this year. She has also kept her BP position, which I think is sensible, and she expects the dividend to be reinstated next year. With a yield of 7.3 per cent the fund is providing a tremendous return in the form of income, considerably ahead of government bonds and comparable to many corporate bond funds.

However, unlike a bond fund, this income stream should rise over the years as dividends increase. I see no reason why high yielding shares shouldn't provide capital growth too, as more investors become attracted to the regular income on offer and push up prices. While Tineke herself is not wildly bullish about economic conditions, she believes the companies in her portfolio should remain resilient. Top line growth may be hard to come by, but she expects to see more merger and acquisition activity, and I suspect this will keep the market moving forwards. So don't give up on equities, particularly the high yield part of market. Whether you want the dividend income or not, it's part of your overall return, a part becoming ever more valuable in the current low interest rate environment.

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