Look to Europe for income
“The aim of the fund is to generate a reliable, growing income stream in absolute terms,” explains Mr Zoellinger. “We do not target a set dividend yield, but we are targeting absolute dividend distribution that can grow over time. The reason for this is that at various points in the market cycle, the available income will become concentrated in riskier areas. If you think of the scenario in 2007, for example, when the yield in the market was quite low as the market was high, if you promised your clients, say, 4 per cent or higher dividend yield, you would have been forced to invest in areas of the market that were highly risky and volatile. Instead, we generate an income stream by investing in quality companies and we have a strong focus on reducing volatility.
“At the moment, we have 4.2 per cent net dividend yield since inception, 25.1 per cent cumulative return over the same period, achieved with 18 per cent less risk than the market. It is risk that is the main thing clients do not like and so we want to reduce it as much as possible.”
One of the key benefits of opting for a European equity income fund rather than a UK equity income counterpart is it represents a much less concentrated income universe. Indeed, there are more than 100 companies within continental Europe that have a market capitalisation of more than €1bn and a dividend yield of more than 4 per cent. The equivalent for the UK is around 30 companies. Within that, while the top-10 dividend payers in the UK account for more than 50 per cent of all the dividends paid in the UK, the corresponding number in the rest of Europe is less than 30 per cent.
“For UK income investors the choice of income assets is much smaller and much more concentrated,” confirms Mr Zoellinger. “If you consider that Vodafone, which paid a very big special dividend after selling off the Verizon asset, is now having to halve its dividend payment going forward, the pool is getting even smaller.
“There is also a great deal of pent up demand and investors are not currently paying a premium for income stocks as European equity income is not a well-recognised asset class yet. To put it into the context of BlackRock, the UK equity income fund launched in 1984, the US equivalent in 1986, while the European equity income vehicle was not launched until 2010, with this fund following in 2011. There simply is not a strong tradition in the market of investing in European equities for income generation. It also allows for better diversification in terms of portfolio construction, achieving a better risk-return balance by combining UK-based and European equity income strategies.”
In terms of the types of stocks the managers look to include in the fund, the main strategy for reducing risk is to opt for high quality companies with a steady dividend stream. Quality is defined, in this instance, by a company having good earnings visibility, adequate balance sheet cover, strong corporate governance and good visibility that the dividend will be paid and, if possible, will rise over time.
“We also avoid the most volatile areas of the market on a sector level,” adds Mr Zoellinger. “So, for example, we do not have any mining companies in the fund at the moment and the same with autos. We only have 3 per cent of the total fund allocated to banks and, up until May this year, that figure had stood at zero. We avoid areas that do not create value over a market cycle and also those where we cannot be sure that the dividend the management promises us will actually get paid.
“In addition, we are allergic to dividend cuts and want to avoid them at all costs. That means that if we have the slightest doubt that the dividend is safe with any of the stocks in the fund, we sell immediately.”
Mr Zoellinger is keen to stress that the fund is “benchmark aware, but not benchmark constrained”, with it quite deliberately entrenched in the philosophy of the fund that it can diverge from the index significantly if the managers see fit. This ties in with the absolute returns mind-set, which centres on maximising the total return over a 12 month view, albeit as a long-only fund. As such, every holding is given an absolute weight of between 1.5 per cent to 3.5 per cent, which is not relative to the underlying benchmark.
“We see it as an old-fashioned but effective way of investing. It is what people did in the 1960s and 1970s before the industry become obsessed with benchmarks,” he says. “As a rule, we do not like benchmarks as they are very volatile and always have the wrong sectors with the wrong weightings at the wrong points in time.
“Instead, we have a high degree of flexibility in terms of our sector allocation and positioning. Some of our competitors have a strategy where they are always overweight in certain sectors, no matter what is happening in the economic cycle. We think we can do better than that, utilising the large team we have on the European equities desk. We are lucky to have a lot of highly skilled analysts who are there to give us good ideas. This means that at various stages in the economic cycle we shift the allocation to various sectors to maximise performance.
“However, while we do take a top-down sector view, we are bottom-up stock pickers at heart. If, as sometimes happens, the top-down and bottom-up views come together, we take very large positions on both a stock specific and sector basis. In the end, though, it is always the stock specifics that drive the portfolio, with each of the 41 holdings having to justify its place.”
At the moment, the fund is overweight healthcare, where the managers are finding attractive stocks with good yields and growth opportunities. Similarly, they are playing a theme of “undervalued defensives”, which includes a lot of the large-cap pharmaceutical names. Continuing on the thematic line, infrastructure continues to play a significant part in the portfolio, with holdings in Italian toll road operator Atlantia and French toll road operator Vinci. According to the manager those assets became attractive two years ago, when a political risk premium was being priced in while the companies themselves maintained a good dividend paying culture, cash flow visibility and were trading at good multiples.
Moving forward, Mr Zoellinger anticipates that the fund will remain focused on stocks that look likely to pay a special dividend, as well those with exposure to international growth trends. The fund remains underweight basic materials, consumer staples and energy.
“Looking back at the performance we have enjoyed to date, if you consider the period from May 2007 to December 2011 the key was to be very defensive, with low beta and a strong focus on dividend sustainability. Initially with the fund we were very overweight consumer staples and pharmaceuticals and underweight financials. From the beginning of 2012, the market turned increasingly positive on economic development and there has been significant risk premium compression based on the improvement in the political situation. We now have a stronger focus on dividend growth,” he says.
Overall, the fund benefits from having a high quality, low risk bias and the flexibility within the way it is structured to be dynamic in terms of portfolio positioning. The managers hope it will continue to prove popular among investors who are seeking greater diversity in their income stream and are prepared to look outside of the UK at a pool of companies that provide excellent potential.
