Three Buckets for Income Investing

Peter Toogood: Good morning.

Cook: So it seems almost like the normal supply and demand rules aren't really applying in the income environment. Investors are demanding income and they're just not getting it. What do you see in this environment?

Toogood: Yeah, it's very hard. I mean, at the end of the day, the reason we're here is because the authorities are basically forcing you into risk assets. I mean, the game here is to create a wealth effect. Yes, we understand why they're doing what they're doing: zero interest rates and printing money is simply about making you go up the risk curve and that means taking on risk. Therefore, as an investor you're forced into that situation, and so you've got a few choices you can take.

You can take the more simplistic approach, which is actually just to go to the credit side of the balance sheet. So, if you think about how you can access income, it's only through companies ultimately—what they produce and how they pay us. So, you can have the credit side of it, which is to take the balance sheet risk, which is through fixed interest securities, be it the most cautious end which is the highest grade credit, through to the more spicy end, which is the high yield, which is more like equities.

The second alternative is obviously to buy equity income itself, where you've got more vulnerability in terms of potential capital loss and you're buying the profit and loss side of the balance sheet to a degree. So, there is the element of the balance sheet stability and then the ability of the dividends to grow is the ability of the company to grow in aggregate. So, there's lots of ways of doing it, but all of this is about forcing you along that risk curve.

From our perspective, the way we look at credit is it’s a long duration asset. So, you've got to think about, if I buy the yield today, you get that back in whatever timeframe the company issues the bond for, now you put that into a collective fund, you've actually got a relatively stable outcome. Unless you actually think capitalism is going to fail, because I always do love the idea that all the governments are going to be alive and all the companies are actually dead. That's not actually going to work in practice. So, what is the risk in buying credit? Really it isn't a massive risk, they do after all pay all the taxes. They either pay us or they pay the government directly.

So buying credit here is relatively easy trade for the lower risk approach, not the lowest risk. Lowest risk is to park it in a bank…well, discuss…to park it into a bank, but the second way I would access income if you're more cautious is the highest end of the grade of credit, and then if you're going to feel slightly more excitable or you don't care about some capital loss but want higher income, go towards a strategic bond and the high yield end of the marketplace; higher yields, more capital volatility.

The ultimate expression of that obviously is to go to the equity income side of the piece, which is to actually expose yourself fully to the potential for a dividend in the UK market, 3.5[%], 3.75[%] dividend in aggregate, higher income fund or income funds near to 4[%], higher income funds perhaps 4.5[%]. The focus there obviously is your initial yield and the ability to grow that dividend over time, which is of course what the equity income gives you is that, potentially the scope for that.

The way we look at income funds there, to separate them off, is we think of it as the ones who think in terms of total return buckets, so here they are thinking about actually these are the companies I want to own, this is what I like, and that's why I own them and they don't really have a reference point to the benchmark.

Then there are ones who think about growing the dividend continuously. So they will tend to have perhaps faster growing and lower yielding portfolios, but they have scope to believe that actually the companies they own will actually grow through time and grow the dividend.

So it's a bit like, do you want to start with 3[%] and have it growing, or do you want to start with 4[%] and have it sort of perhaps growing, or 4.5[%] and have it just there with a very limited potential for it to grow over time, and that's sort of the way you have to think about it.

The third bucket is sort of what we call the index aware merchants. So, equity income defined I think by IMA is 110%. So you've got to do 10% more than the dividend from the market to qualify as an equity income fund. And there's a series of managers who think like that. So you almost get an all share type of an outcome with an income. So they're thinking about the benchmark, but they're giving you just that little bit more. At the moment, if you think about the market and valuations, they're probably the ones you ought to bias yourself towards, it’s the more index-aware income funds that we would think have a better place here given the multiples are quite low. In other words, you probably want to access the ability to grow the capital...in the next decade, by the way, this is not a punt to suggest the market goes up in the next six months. But if you take a 10 year view, if the market rating is at 9, 10 times, average in the UK has been 14 times, you probably want to think about the potential for that to mean revert back up at some point in the next decade, while actually growing your income. So think about the three buckets and those are the ways you can actually expose yourself to equity income.

Cook: So would you say that investors are generally having to take on a bit more risk to get that income, but perhaps if you're looking on this longer-term view, is that perhaps not necessary?

Toogood: No, I think, you shouldn't be worried about it, unless you think – I mean, basically you’ve got to think that capitalism is sailing. I mean, broadly speaking we can be Japan. If you are Japan you're going to have no real rating of equity valuations, but you're still going to get your yield. So if I was to propose to you the following: Glaxo can perhaps give you 5% to 6% a year dividend yield over the next 10 years, and the price of Glaxo goes nowhere. So what? Compared to interest rates of…? Where is your downside in the trading? You actually think Glaxo is going bust? I kind of guess if it's going bust, so are we. And I could apply that to Vodafone and a series of others—this is a very UK conversation—but it's the same principle. Those companies aren't going bust, if they’re going bust, we're going bust. So think about it from the point of view of the investor. Where is the downside in this really? Why would Glaxo derate? And it's chucking off a beautiful yield and growing that yield each year, so it's not a bad entry point, but we're in the fear stage.

If equity markets are defined as greed, fear, panic, despair, disinterest and disgust, we're somewhere between disinterest and disgust. That's sort of the point at which you want to think actually capitalism isn't yet dead, and I don't want to get too bearish, but be aware that there will be volatility. So the simplest way to access that is to think about an equity income strategy and then balance that out with a credit strategy, and then across that have the flavour of the highest grade investment credit, which is the safest element, and perhaps some high yield, that's the sort of income mix that I think advisers should be focusing on to give the investors at least some hope they can still generate an income from their hard-earned cash.

Cook: Well, it sounds like despite that fear, we've still got some positivity at least.

Toogood: Oh, gosh, yes, don't get too bleak. It was easy to be bullish 10 years ago, it's very, very hard to be bullish today, but think about it logically. Mean reversion is a natural phenomenon, and unless you think it's all over, and I don't, I think we're just adjusting expectations for growth, that's what it's all about, and it applies to anything you're looking at today. Once people get into their heads the expectation of growth is 2% or something, companies can still earn good money at 2% growth rates, GDP at 2%, 1%, 2%. It's not the end of the world; it's just a different world.

Holly Cook: Yeah. Well, thanks very much for joining me, Peter. Sounds like the message is keep investing. Thanks for watching.