Selecting stocks purely on yield has its dangers. Firstly, rising markets may result in a reducing universe of stocks meeting the yield target. Over the last year, for example, the number of stocks around the world yielding 4%+ has fallen to around 400 from over 600 due to rising markets. This situation could cause a dilemma for a high yield manager – do they adjust their yield requirement downwards or do they just accept that they have a smaller pool of stocks from which to select? Another issue is that a high yield can also be a sign of stress when a fall in a company’s share price is artificially inflating the estimated yield. Indeed, research has shown that the higher a stock’s estimated yield is, the more likely the actual yield is to disappoint.
2. Barbell managers
At the opposite end of the scale are those equity income managers who buy a high percentage of capital growth stocks which offer very little in terms of yield, and then look to boost the fund’s income by holding some bonds or very high yielding stocks. This is known as a ‘barbell’ strategy. An advantage of this approach is that it gives the manager a much wider universe of stocks to choose from. However, this method can increase the fund’s volatility given that the underlying holdings tend to be predominantly growth stocks. The income profile can be more volatile too and so it may well be an inappropriate strategy for an investor who needs to be reasonably sure of the yield they will be receiving.
It is perhaps no surprise that this style generally proved to be successful last year, given that the market had a very good year with cyclical stocks out-performing defensives and small/mid cap stocks doing well. Selecting this approach could make sense for an investor with a medium-term view where the outlook for the market is bullish. However, we believe it is less likely to prevail over the long term. This means that an investor will need to monitor the barbell fund closely and potentially make a change if market conditions turn against the style.
3. Bottom-up managers
The third way is the one I adhere to in my funds. The strategy largely involves selecting solid stocks based on an assessment of the company’s earnings and its dividend payout. Rather than investing solely on the basis of a stock’s yield, my approach places great importance on dividend sustainability. Investments are made with a view to capital preservation based on a detailed consideration of valuation, stock and industry fundamentals which informs my view of the downside and upside potential of any portfolio candidate. I also look for stocks with the potential for dividend growth which helps with my aim of increasing the dividends from my funds at least in line with inflation each and every year.
