In association with
The adviser’s guide to income investing
Chapter 1
The future of income
Chapter 2
Moving along in the economic cycle: the hunt for quality stocks
Chapter 3
Case studies: investing in controversies
Video
Focusing on the long term
Podcast
How can investors face down inflation?
Key takeaways
An inflationary and rising rate environment offers a positive backdrop for income funds across the globe. Income strategies could be used by investors to hedge against inflation. The market backdrop will remain volatile, and therefore ‘suffering’ this volatility is going to become more important as a result.
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With inflation hitting multi-decade highs and interest rates climbing globally, investors finally seem to be rethinking their approach to equity income funds
Following flat net retail sales in 2021, according to the Investment Association (IA), we have seen net retail sales of £1.35bn in the IA Global Equity Income sector during the first four months of this year. Indeed, in April, while Global Equity Income was the top seller among all sectors, attracting inflows of £678m, the IA Global sector – which last year took in net sales of £12bn – was languishing near the bottom of the table with outflows of £216.5m. So what has caused this turnaround in sentiment? And is it here to stay? “During the past few years a number of companies have gone up in a straight line, and it appears some investors forgot about valuations and simply focused on getting rich quick,” says Nick Clay, manager of the Redwheel Global Equity Income Fund. “However, this has hit an abrupt halt with the arrival of inflation.” For Clay, a combination of surging inflation, rising interest rates and geopolitics, has reminded investors there are different ways of building wealth over time – and that building wealth slowly is a strategy that has traditionally worked well in the past. “In a more volatile environment, which we could be in for some time, we believe the makeup of your total return between capital and the compounding of income will become more important – because markets aren’t heading to the moon anymore,” he says. “Therefore, an income strategy that can focus on the durability of the dividend, and be able to compound that through time, should serve investors in good stead against this market backdrop,” he adds. Clay makes the case that income strategies can be used by investors to hedge against inflation, which in the UK hit 9.1% in June, the highest figure recorded since 1982. “If you go back through time and look at dividend growth from companies, the rolling 12-month growth from the MSCI World Index matches that of US CPI (Consumer Price Index) very well,” he says. “This is because companies can raise their prices and therefore grow their profits in nominal terms, allowing them to increase their dividends and providing some form of inflation protection.” After income funds underperformed their growth counterparts for most of the past decade, Chris Metcalfe, investment and managing director at Iboss, believes the turnaround in the relative fortunes of the sector is still very much in its infancy. “The pandemic ultimately created poor market conditions for a significant number of sectors, which provide most of the higher-dividend payers such as banks”, he says. “Not only were many companies’ business models under pressure but governments actually dictated that some companies couldn’t pay dividends. “This is no longer the case and with an inflationary backdrop – which we never thought was transitory – and a rising rate environment, this looks like a positive backdrop for income funds across the globe.” So what are Clay’s thoughts on inflation moving forward? He admits that, at the start of this year, he was in the camp that believed inflation would be transitory. “The war in Ukraine has obviously made inflation more sticky and permanent, and even higher than we probably thought it was ever going to be,” he says. “However, I still believe we will look back at the summer period of 2022 as being peak inflation.” The problem, he adds, is that when inflation does settle down it will remain “uncomfortably high” for the central banks. It will likely sit in the 3-4% range rather than reverting back to the 2% level. “This simply means the market backdrop will remain volatile – and therefore ‘suffering’ this volatility is going to become more important,” he says. “As a result, seeing companies in my portfolio increasing their dividends anywhere between 5-10% on average is going to serve the fund well in an inflationary backdrop of 3-4%,” he adds. “It means the portfolio should be able to generate at least a decent nominal return to compensate for that inflationary backdrop.”
The information shown above is for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.
Disclaimer:
‘With an inflationary backdrop and a rising rate environment, this looks like a positive backdrop for income funds across the globe’
investment and managing director, Iboss
Chris Metcalfe,
Back to home
Against an inflationary backdrop, companies that tend to do well are those with pricing power, such as consumer staples. Sectors that are wrongly perceived as cyclical – including luxury goods and semiconductors – should also fare well. Now is the time to be hunting for quality stocks that are able to suffer or just simply survive amid this environment of slow growth and volatility.
Nick Clay, manager of the Redwheel Global Equity Income Fund, is backing consumer staples, luxury retailers and semiconductors as the winners in today’s rising inflation conditions
According to Nick Clay, the last time inflation has risen in such a straight line was from the 1950s to the beginning of the 1980s. “I cannot claim that I was running money during these periods. However, I have managed portfolios during times when interest rates have been rising and falling,” he says. “What this experience has taught me is that you have to invest in companies that have the ability to suffer against this backdrop – and this means they need pricing power.” This allows companies to pass the inflation of their cost base onto their customers, explains Clay, namely by raising the prices of the products they sell. “You have the classic staple products such as shampoos and deodorants,” he says. “Companies can raise their prices because they know people need them, and being overweight in these staples has served the fund well over the course of the past year.” However, heading into an inflationary environment, Clay adds the fund has been moving into areas that have been underperforming, but which the team believe may do well going forward: namely luxury retailers and semiconductors. “Both of these areas are being treated as highly cyclical at present, which we think is totally misplaced and is based on an historical view of these industries,” he says. Taking luxury retailers, such as Richemont’s Cartier, Clay believes such companies actually have “perfect” pricing power. “The cost of a Cartier piece of jewellery is de minimis to the price they set, with the average selling price being about $20,000,” he says. “So they have pricing power and, ironically, the more they seem to put up the price of goods, the more people desire them. Unsurprisingly, these customers tend to be very wealthy so they can cope with most economic cycles.” So while not cyclical and still having pricing power, Clay says luxury retailers are being treated as if the oligarchs of Russia were the only ones who shopped at Cartier, or that the lockdown in China will be a feature forever. Since neither is true, he thinks this represents a great opportunity in the portfolio at present. Similarly, he says that while semiconductors have traditionally been perceived as cyclical in nature, this is less true today. “During the past few decades, the semiconductor sector has become a far more capital intensive industry and therefore much more monopolistic,” he says. “As a result, it is not so cyclical and is more about pricing power and structural growth. Yet, in bear markets, time horizons seem to shorten dramatically and the sector has been labelled cyclical.” While finding opportunities in these areas, in addition to consumer staples, utilities and healthcare, Clay says there are also traps to avoid , such as those companies that are “takers of cost”. “What we are seeing this time around, unlike in previous cycles, is that because we have been in a disinflationary cycle for such a long period of time, many business models have been born in this environment,” he says. “As a result, their whole way of running the company is based upon this disinflationary backdrop.” Taking the example of low-cost retailers, Clay notes that in a situation in which prices are rising and their cost base is increasing, their business model does not allow them to raise prices for the customer because they are already run on “very thin margins”. “This is a new breed of a company and it will be an interesting experiment to work out where they are suffering.” Based on the view that we are “late” into the economic cycle, Clays believes the window of moving from growth into early-cyclical, deep-value stocks has now passed. Instead, he argues that now is the time to be hunting for quality stocks that can suffer or simply survive in the slow-growth, volatile backdrop that is coming.
‘You have to invest in companies that have the ability to suffer against this backdrop – and this means they need pricing power’
portfolio manager, Redwheel Global Equity Income Fund
Nick Clay,
The best time to go fishing for global equity income is when companies are mired in controversy. Tapestry is an aspirational brand with pricing power. The company has been mispriced by the market in light of a possible recession and cost of living crisis. Samsung dominates the memory industry and so is in a great place to suffer any form of slowdown.
While remaining wary of the valuation risks that exist in the world’s largest companies, Nick Clay, manager of the Redwheel Global Equity Income Fund, is increasingly positive about some of the valuation anomalies he sees developing across the globe
Amid conditions in which growth markets are stalling and inflation and interest rates are rising, Clay believes genuine long-term opportunities can be unearthed. Indeed, he argues that a strategy which places more focus on granting its total return from income, rather than capital growth, may be much better placed for the coming 10-15 years. For Clay, who joined Redwheel with three of his team from Newton in 2020, the best time to go fishing for Global Equity Income is when companies are mired in controversy, and in this article we detail the investment case for two such stocks. A longstanding holding in the portfolio, Tapestry is a US-listed, multinational luxury company and the parent of the Coach and Kate Spade brands, which sell mostly luxury bags. “A global focus from governments to increase the middle classes very much plays into Tapestry’s hands,” says Clay. “It is an aspirational brand and as people move into the middle class they want to buy Coach and Kate Spade handbags. “At the same time, because of the nature of their product they have pricing power, which is a big advantage within the luxury retail space,” he adds. “Tapestry can raise its prices and it may not hit their volumes.” However, having survived the pandemic, Clay says the concern within the market now is that Tapestry will be a victim of a possible upcoming recession and cost-of-living crisis. “I think the possibility of Coach going bust in five to six years’ time is very low,” he says. “Instead, it is an exciting company, which plays into a structural part of the market that is well supported at the moment, not just in one area but across the globe – from China, to America, to Europe. “Tapestry recently announced that over the coming 12 months it’s going to return $1.8bn to shareholders, which is more than 25% of the company,” he adds. “The fact it has been priced to go bust seems a bit mad.” Given that Clay and his team are buying stocks many people wouldn’t and selling them when most people are in love with them, he says investment disciplines are vital and are the starting point of the fund’s entire investment process. When it comes to buying, the team’s discipline only allows them buy a company when it yields 25% above the market yield and to ensure the team never fall in love with a stock, they must sell them when they yield less than the global market. Another company about which Clay believes the market has become too pessimistic is the South Korean technology conglomerate Samsung. “Samsung today is valued on eight times price/earnings and one times sales,” he says. “It is being valued as if the cycle is going to be as terrible as it has been historically – and yet all the evidence suggests this is not going to be the case. “Samsung dominates the memory industry in terms of capital expenditure and the evolution of its products, and therefore is in a great place to suffer any form of slowdown. This is a sector that is massively short of supply and hugely strong on demand,” he adds. “It is a great starting position for a company that is valued as if it is going into the depths of a cycle.” First added to the fund over four years ago, Clay says it was bought on the thesis of Moore’s Law – which means you get more for less – breaking down in certain parts of the technology market and the cycle not being as great as investors feared. “Ahead of the last cycle this proved to be exactly right as the cycle was far less amplified than it had been in the past,” he says. “Yet here we are again and we think this is another great opportunity for the stock.”
‘Samsung is being valued as if the cycle is going to be as terrible as it has been historically – and yet all the evidence suggests this is not going to be the case’
Tapestry
Samsung
There are different ways of building wealth over time. An income strategy that can focus on the durability of the dividend, and is able to compound that through time, should serve in a good stead against this kind of market backdrop. We obsess about companies that are durable, able to suffer and which can pay us a dividend even when things are going wrong.
In this video, Nick Clay, portfolio manager of the Redwheel Global Equity Income Fund, highlights what an income strategy can bring to a client’s portfolio – and how the team use discipline over emotion to find the best opportunities
How can income investors face down inflation?
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.
‘The longer you give it, the greater the power of the compounding income becomes. It should be a core holding in most portfolios’
Focus on companies with pricing power. Businesses that can raise their prices are able to grow their profit in nominal terms, and therefore can increase their dividends. This gives you some kind of inflation protection. Compounding a dividend over and above that of the market tends to dominate your total return. So, compounding of that dividend is less volatile than capital return.
Adam Lewis, Bonhill content editor, and Nick Clay, portfolio manager of Redwheel Global Equity Income, discuss where we are in the economic cycle today – and how income could offer a hedge against inflation as bonds and equities fall in tandem
‘The interesting risk rewards in the market now, rather than the obvious staples, utilities and healthcare, are in the semiconductors and some of the retail space’
How can income offer a hedge for inflation?
