The Rathbone strategy is not overly complicated; in fact part of its charm is that the process is eminently logical. Yarrow uses an initial screen to target stocks with high returns on equity and sustainable strong free cash flows. Stocks preferred typically display attributes such as low debt levels, high barriers to entry and pricing power, with sensible expansion plans
that will not come at the cost of dividends.
Yarrow’s penchant for companies with stable cash flows unsurprisingly leads him to large-cap stocks. As one would expect for a fund with an income mandate, the significant overweight positions are in typically defensive sectors such as telecoms and utilities – companies here tend to offer investors steady income streams. However, Yarrow is also diligent and consistent in his search for yield. The healthcare sector, and large pharmaceutical companies in particular, attract managers for their defensive qualities and yield but Yarrow avoids them because he believes their patent risk and competition from generic manufacturers will erode cash flows over the long term. Hence the fund currently has no exposure to the healthcare sector. In contrast, he liked lift manufacturer Kone because it benefits from long-term maintenance contracts for its lifts and these provide a stable income stream that can lead to steady and rising dividends.
Although Yarrow’s process has led to a trailing 12-month yield higher than the average fund in the IMA Equity Income sector, we would raise a note of caution about some potential risks the fund harbours. During his short tenure, Yarrow has shown a willingness to let valuations runs fairly high. For example, on the back of recent relative strength, utility companies such as Scottish and Southern Energy and National Grid are starting to display more growth-like characteristics. While paying a higher price for quality issues can sometimes make sense, it also introduces an element of valuation and price risk involved which can make the fund more volatile. Moreover, although it has a large-cap emphasis, the fund has greater exposure to small and micro-caps relative to its average peer which can heighten the fund’s volatility and liquidity risk. The fund is still small and nimble so that latter is not a major concern yet but it is worth keeping an eye on.
Taking all into account, we think Yarrow’s strategy is robust and has the potential to serve investors well over time. However, he is young and lacks the experience of guiding a fund through different market cycles. Although the current market turmoil will bolster his experience, given the high level of competition in the equity income space, we think many investors would prefer the comfort of a more established offering run by a seasoned manager. However, we do believe Yarrow shows promise as a manager and we’ll be keeping a close eye on this fund.
