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Emma Wall: Hello and welcome to the Morningstar TV series, ‘Why Should I Invest With You?’. I am Emma Wall and here with me today is Colin Morton, manager of the Franklin UK Equity Income Fund.
Hello, Colin.
Colin Morton: Hello there. Thanks for inviting me.
Wall: So, the first thing I wanted to talk about is you advocate income funds not just for income seekers. Why is that?
Morton: Well, if you look back over the longer term, if you invest in income stocks, you tend to produce a very, very good overall total return. So, if you go back, say, over the last 20, 25 years, despite what’s been a very difficult five years or 10 years recently, the FTSE 100 Index has stilled return something like 700% over that period. Of that 700%, roundabout 500% of it has actually come from the income and the reinvestment of the income. So, total return – the income part of total return – is a very, very important part of it.
Wall: So, Einstein was the one who said compound interest was one of the Seven Wonders of the World, is that true?
Morton: That's right. I mean, it is fantastic what it does. If you just get a calculator sometimes and you just sort of tap in 7% or 8%, you just keep multiplying it by itself, it’s amazing how quickly that number turns into a very, very large number. As I say, once you get on to things like 20 years, 25 years, that number just becomes bigger and bigger all the time. You’re quite astonished yourself sometimes by what seems quite a small number to start with, but obviously over time ends up being a very, very large number indeed.
Wall: But it’s not just about chasing that highest possible yield, is it?
Morton: Definitely not. I think that's one of the biggest mistakes that can be made. That doesn’t mean that the highest yielding stocks might not be good value. But what you’ve got to do is a lot more work than just looking at absolute levels of dividend yield. You’ve got to do a lot of work on the balance sheet of the company, and the thing that we focus on really, really tightly is looking at free cash flow of the company. So, what we're trying to find is a company where the free cash that they generate is substantially above the dividend yield that they're actually paying out.
Why we like companies like that is because it gives you the comfort of knowing that the company isn’t giving everything out to shareholders, or more than what they’re generating to shareholders. It gives you that comfort of knowing that they can go through a difficult period of time and they can still afford to pay out the dividend. So, for example, a dream world is to find something yielding 6% or 7% who could afford yield 11% or 12%. As you can imagine, there is not many of those companies around. But typically our average company will be yielding, say, about 4%, 4.5%, but they’ll have a free cash flow yield that’s something like 6.5%, 7%.
Wall: So, perhaps is that sustainability one of the challenges the income investors face?
Morton: Without a doubt. I mean, that’s where the work has to be done. We spend nearly all of our time, as again I said, on this free cash flow, looking at can the company grow that free cash flow, can they grow the dividend over the longer term, because that's where – we just had the discussion about compounding at the beginning – and that’s really where the big returns will come from over the longer term; finding those companies that have got the ability not just to pay out a dividend now, but to grow that dividend in real terms over the medium term. That is the important thing that, I think, people sometimes forget about investing in equities, full stop. What you're really doing when you're investing in equities is you're trying to protect your money in real terms, and so what we're trying to identify is those companies that have got the ability to grow their profits and grow their cash flows and hopefully their dividends above inflation over the medium to long term.
Wall: Colin, thank you very much.
Morton: You’re welcome. Thanks for having me.
Wall: This is Emma Wall for Morningstar TV. Thank you for watching.
