Last year may have been one of unexpected events, but one trend that has remained constant is investors’ demand for income.
This was especially evident in the investment trust sector, where infrastructure, real estate and other ‘alternative income’ offerings were among the most successful at raising new capital last year.
The premia on which some of these trusts now trade conveys confidence in their enduring popularity. However, the macroeconomic winds are changing. Investors are looking on the bright side, predicting that greater fiscal expenditure, lower taxes and a looser regulatory framework in the US will prove restorative and engender stronger economic growth and inflation. This could bode ill for the sustainability of the premia on some alternative income trusts, as investors gain access to a deeper pool of income opportunities thanks to rising yields.
Is such ebullience warranted? There are reasons to be sceptical. The disinflationary forces of ageing demographics, technological change and high levels of debt persist, and Donald Trump’s reforms may not be as effective as many hope. Furthermore, the forces behind globalisation appear to be waning and upcoming European elections could facilitate political turmoil.
Rather than predict the course of events and investors’ reactions to them, we take a balanced approach and invest with income managers anchored on underlying corporate fundamentals.
A good example is Evenlode Income, managed by Hugh Yarrow and Ben Peters. Instead of tweaking the portfolio’s sails to suit the prevailing economic winds, they place their faith in the compounding power of asset-light, cash-generative businesses that earn high returns on capital. Examples include Diageo and Unilever as well as smaller companies such as Fidessa, the UK software provider. While the quality characteristics of such businesses have also made them fashionable hunting grounds for many income investors, to describe them simply as bond proxies would be a mistake. Evenlode own dynamic businesses with durable franchises and attractive pricing power, which means they are able to grow in different economic environments. Such attributes should ensure they increase their dividends ahead of inflation over the long term.
Another income fund we own is RWC Enhanced Income, managed by the experienced team of Nick Purves, Ian Lance and John Teahan. Like Evenlode, RWC’s largest holdings are in stable businesses such as GlaxoSmithKline and Microsoft. Alongside the team’s consideration of quality runs a strong valuation discipline which has resulted in the fund having a high cash weighting – in excess of 20 per cent in recent years.
Enabling such prudence is the boost to income that comes from writing covered call options on the portfolio’s underlying constituents, an approach that leads to a 7 per cent dividend yield for the fund. Although such a strategy constrains capital growth in strongly rising equity markets as options are called, it helps dampen volatility during sluggish markets and periods of dislocation. This should allow RWC to better protect its investors’ capital and leaves it well placed to deploy the fund’s dry powder as and when more attractively valued opportunities emerge.
