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Strategy: In the market for income generators
The UK equity market has enjoyed its best performance since the final quarter of 2003, as the rally that started in mid-March continued through the current economic recession towards the prospect of recovery. As a result, the rally was led by a return to favour of cyclical sectors, which sold off aggressively during the downturn. Meanwhile, more reassuring US and Chinese economic data and stronger commodity prices benefited oil and mining stocks.
It was the previously hardest-hit sectors that experienced the strongest gains. As was evidenced by the better-than-expected results from several banks that boosted the UK financial sector. Cyclical sectors, including automobiles and industrials, benefited from the increased optimism over the global growth outlook.
Positive news flow from some retail and travel and leisure companies also led to higher share prices. In contrast, investors took profits in previously stronger-performing defensive sectors, including tobacco, pharmaceuticals and telecoms, as they sought better value elsewhere.
The concerted policy action taken by global authorities has helped to stabilise economic activity, and the pace of earnings downgrades has lessened. Even in the absence of a sharp economic recovery, there is support for the UK equity market from its low valuations levels in terms of free cash flow dividend yield. The low returns available from asset classes such as cash and gilts currently accentuate the value available in UK equities. While market volatility remains at elevated levels, there are plentiful opportunities for the income investor.
Against this backdrop and changing landscape, where can investors find sources of income? A big advantage for equity income investors is that, not only are there many high-yielding stocks to choose from, often these stocks are UK firms with an international reach, which leaves them less exposed to sterling's misfortunes.
One such area that is presenting opportunities for investors is within the FTSE 100 index, where there is a dominance of higher-yielding stocks among the very largest capitalisations. For instance, companies such as BP, Royal Dutch Shell, GlaxoSmithKline, Astra Zeneca and Vodafone all yield more than the market. This has led to the 10 largest income contributors in the index accounting for nearly 60 per cent of the total market's yield.
Another income-generating sector is tobacco. The sector offers attractive yields that are continuing to grow. For example, Imperial Tobacco, which is in the process of paying down the high levels of debt incurred in its acquisition of tobacco, cigar and cigarette producer Altadis, which was announced in January 2008, should see its shares rerated as this is finalised.
The utility sector is more of a mixed bag, where a tough settlement by the regulator, Ofwat, is threatening overall dividend levels. On the other hand, Centrica appears to be attractive with its acquisition of Venture Production, reducing earnings volatility as a result.
However, there are some extremely attractive yield opportunities in the small-cap area of the market. Due to liquidity fears and general risk aversion, many small-cap stocks were very weak earlier this year. What's more, many of these companies have significant director share holdings ensuring there is continuity of interest with outside shareholders as per the continued payment of dividends. The influence of personal wealth being at stake also means management are very aware of downside risk, which has often led to cautious balance-sheet management.
