A long-term perspective soothes day-to-day fears

This article is part of
Equity Income - October 2015

Investors are often concerned, even frightened, when equity markets suffer the sort of day-to-day volatility seen in August and September this year.

These moves need to be put into perspective. One of the unfortunate aspects of the reporting of stockmarkets is the emphasis on the closing price of indices – for example, the short-term focus on the fact the FTSE 100 index has fallen from close to 7,000 to close to 6,000 since the spring.

A long-term investor should remember some of the key reasons for buying stocks and shares, directly or via a fund or investment trust. Of course capital gains and losses matter, but over time, study after study shows that the majority of gains from buying shares come from dividends and reinvested dividends. These mount up over the years, especially via the power of compound interest.

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At this stage of the investment cycle, equity income funds also have their rewards, as well as some risks that need to be noted.

Income funds, whether their foundations are equity or corporate bonds or commercial property, are supported by the low levels of interest rates in all the major economies, and thus historically low government bond yields.

Put another way, it is well known that the gap between dividend yield and government bond yield is rather wide. On top of this, a useful feature of the UK and US equity markets has been share buybacks, adding about another 1 per cent to the yield on average. Compound average annual dividend growth was 4.6 per cent for the FTSE 100 and 6.7 per cent for the FTSE 250 from 1986-2015 – though those figures do include a period when inflation was rather higher than today.

A turning point in the cycle beckons – or perhaps a fork in the road is a better distinction. Central banks in the UK and the US have been at pains to warn markets that interest rates could start to rise, if the necessary conditions fall into place.

If this does happen, and base rates rise every three or six months, then of course the yield from equity income funds will need to be reassessed. However, another aspect of the Monetary Policy Committee’s or the Federal Reserve’s decision also needs to be considered – the only reason why they would want to tighten monetary policy is if the economy is strong enough.

We look to be a world away from the top of an inflation cycle. Such a background should be helpful for corporate sales and company earnings, particularly for smaller firms.

What about the other fork in the road? There are undoubtedly risks ahead.

Emerging economies are in a long, drawn-out slowdown, which is feeding through into worries about the profits for corporates elsewhere. Geopolitical risks are mounting, for example in the Middle East, while the regulatory environment is not always supportive for business.

The good news is that stock selection can help in difficult times. Fund managers can look for firms with strong corporate balance sheets, reflecting the fact that dividend cover on FTSE 250 stocks is about 2.25 times, versus just over 1.5 times for FTSE 100 firms. Capital gains and losses do matter if the effect has to be crystallised. Otherwise, in a lengthy environment of low inflation and low yields, many investors will appreciate the advantages from holding equity and other income-producing assets to help protect portfolios and provide long-term returns.