Don't write off income funds, says Threadneedle

Equity income funds have underperformed growth funds so far this year, but Threadneedle believes that rumours of the income sector's demise are exaggerated.

Chris White, a Citywire AA-rated member of Threadneedle's income team explains: "As earnings growth becomes harder to find, there is a natural tendency for companies offering genuinely sustainable growth to outperform. However, when conditions get really tough and equities come under pressure, dividends become a more important component of total return. That's certainly the situation now."

Income stocks boast many of the cash flow characteristics that investors will be looking for as economic conditions deteriorate, but it is important to concentrate on quality, says White: "At the moment there are lots of companies offering superficially attractive yields - 41 stocks in the FTSE 100 yield more than 4%, for example. However, not all of those yields will be sustainable because some companies will have to cut their dividends and two of them so far are being paid in scrip form.

"What we are looking for are companies with good dividend cover - say 1.5 or 2 times - and strong cash generation, where we are confident that the dividend can be maintained or, preferably, grown. Adhering to this maxim should lead to a portfolio of well-capitalised companies where a healthy yield makes a good contribution to total return and provides some downside protection."

White believes that income investors could receive an additional fillip in early 2009: "We have been thinking for a while now that as long as commodity prices don't lurch higher and wage pressures remain under control, the Bank of England may cut interest rates in Q1 2009," he says. "This will be good news for banks, industrials, utilities and telecoms - four of the highest yielding sectors in the market. Meanwhile, the select band of truly sustainable growth stocks will become ever more select as the economy reaches its nadir, and ‘supposed' growth stocks that fail to deliver (because they are actually cyclicals) will get severely punished by the market. This suggests to us that income funds should resume their long-term out-performance of growth."

Whilst cautious on the economy and the market in the short term, White has encouraging words for patient investors: "Yes, things are going to remain tough in the coming months and they will probably get worse before they get better. But they will get better and, in the meantime, depressed prices mean that we can pick up some excellent companies at once-in-a-cycle yields. That, to me, is an exciting opportunity."