The principle of income safety is central to my process on the Fidelity MoneyBuilder Dividend and Fidelity Enhanced Income Funds. I look to define ‘safety’ by answering three core questions when analysing a stock:
1. How sustainable are company returns through the economic cycle? I want to see strong and robust cash flow with low correlation to the economy – and a strong balance sheet.
2. Is the dividend covered by cash flow?
I have explicit dividend forecasts for my fund holdings and I look at whether the company has enough cash to cover current and future dividends.
3. What is the expected compounded return over the long term?
I analyse the company’s internal rate of return in the context of the company’s current valuation to understand the potential opportunity which may exist.
For me it is critical to understand how robust the company is: its profit record, financial strength, competitive position, and profit and dividend forecasts. I will sell out of a position in the event that a dividend looks unsustainable or is at risk of being cut.
In my view, equity income funds should only invest in stocks that deliver safe and growing dividends. I believe income sustainability is particularly relevant in the current environment, where the economic backdrop is resulting in some companies looking to cut or cancel their dividends. Funds investing in dependable dividend stocks are typically less volatile than the wider market and low volatility is a characteristic of my funds. Of course, by taking a more risk-averse approach we do have to accept that this style will not necessarily result in sector-leading performance in bullish markets. However, the approach may be the most suitable for investors seeking stability and dependable income payments.
Buyer beware
Knowing what type of fund you are investing in is, of course, vital. A sizeable market correction could be a big shock for an investor who believes their equity income fund is more cautious than it actually is. Perhaps a good example of how people can be caught out is to look back at recent history. Advisers will recall how some seemingly safe corporate bond funds acted more like equity funds than fixed income investments during the initial phases of the market crisis of 2007/08. We are not suggesting a similar scenario will occur within the Equity Income sector. However, you only need to look at the volatility numbers to see that some investors could be in for a surprise.
