Rathbone Income: Steady income on top of capital growth

Chetan Modi, fund analyst at Morningstar: Manager Carl Stick plies a strategy that we think is fundamentally sound and has led to this fund’s continued success. He looks over the long term for companies that offer healthy yields and can grow their dividends by at least the rate of inflation each year. Stick searches for cash-generative companies to increase the security of dividend payments and focuses on a stock's free cash flow yield as well as a company's earnings in relation to its fundamental value (EV/EBITDA). He also keeps a close eye on leverage by assessing a stock's return on invested capital versus its weighted average cost of capital.

Stick’s strategy has led to strong returns over the past five years versus its average Morningstar UK Mid Cap equity peer, but if we narrow down the category to those focused on providing income for investors, we find this fund has performed well against its peers. Stick has outpaced his closest income-focused mid-cap rival by an annualised 11 basis points since the beginning of his tenure in January 2000 to the 15 November 2008 and this has been achieved with an average level of volatility.

The fund's trailing 12-month yield is slightly higher than the average fund in the IMA Equity Income sector, but like most equity-income managers, Stick’s search for yielding stocks could be more difficult going forward. Since the credit crunch started to grip the markets, the banks' ability to pay dividends has become questionable which removes a key dividend-paying sector from his universe. Stick raised the fund's exposure to industrial materials slightly in 2007 in his search for yield but exposure has since been cut back as a result of rising valuations. Tobacco stocks, also popular with income managers, are also off-limits because valuations have been pushed up as investors go defensive. The underweight positions in overvalued sectors with yield such as metals and mining, tobacco and energy have hurt the fund's income but has helped preserve capital as those particular sectors have been hit badly in 2008 so far. Nevertheless, Stick has used his experience further down the market-cap ladder to ferret out stocks with rising yields. For example Northgate, the commercial vehicle rental business, has been steadily growing its dividends above the rate of inflation for almost a decade.

We are pleased Stick shows complete conviction in his strategy, even during a tumultuous year and the fund's turnover has remained low at 35% for the year to 30 September 2008. This highlights Stick's long-term disciplined approach, despite being forced to trade more than usual given the turbulence in the markets.

The value bias inherent in income strategies has been out of favour with the markets - the Morningstar UK Large Cap Value equity category lags its growth counterpart for the five-year period to the end of August 2008 - but this fund has still performed remarkably well, which is a testament to Stick's skill. Moreover we have seen that in recent months the Morningstar value categories have been outperforming the growth categories.

The past few months are too short a period to make a strong case for value stocks just yet. However, we believe this fund is well positioned to benefit when the market recovers.

Strategy

In keeping with this funds income mandate, Carl Stick assesses a stock's free cash flow yield to look for stocks that are offering healthy yields and have the ability to grow their dividends by at least the rate of inflation. Finding stocks with attractive valuations is also key to Stick's process - he looks at a company's earnings in relation to its fundamental value (EV/EBITDA) and Stick will trim a holding if, in his opinion, valuations begin to reach an optimum level. Stick avoids heavily indebted companies by keeping an eye on a stock's return on invested capital versus its weighted average cost of capital. We think the strategy deployed here is fundamentally sound and leads Stick to solid businesses with strong cash flows which we believe will deliver outperformance over the long term.

In looking for companies that fulfil those criteria, Stick will look across the market-cap spectrum. He allocates a sizeable portion of the fund to dividend-paying large-cap companies that provide income to the fund but it's not unusual to see around a quarter of the fund's assets invested in small- and micro-cap stocks which introduces some liquidity risk to the fund. To keep this in check, Stick will not hold more than 8% of a company's quoted equity and he avoids investing more than 4% of the fund in a single stock.

Small and mid-cap company research is done almost exclusively in-house and company visits usually occur twice a year. Rathbones will also carry out their own research in respect of smaller FTSE 100 companies. Rathbones currently runs around £1 billion in this strategy.

Management

We think Carl Stick is an experienced and talented manager who adds value for investors over the long term. Stick spent 18 months running private client mandates before taking over this fund in January 2000 when it was £9m and owned purely in-house. The fund has since grown to just under £800 million as at the end of October 2008. Stick also manages Rathbone Special Situations and assists on Rathbone High Income. Hugh Yarrow has been working alongside Stick since the beginning of 2004 and undertakes fundamental company and sector research, he also manages the Rathbone High Income fund with support from Stick and CIO Julian Chillingworth.

Alan Dobbie and Elizabeth Davis support the research for this fund and other Rathbone offerings. Dobbie, who joined the firm in 2005, performs sector analysis and company specific research with a particular focus on. European equity exposure for Rathbone's income mandates. Davies is a quant analyst and profiles risk across Rathbone's fund range as well as researching property and speciality finance companies.

The remuneration structure for Stick and his team is based on the profitability of the asset management business as a whole rather than fund performance. We like the fact that a portion of the awards are deferred for three years, encouraging manager retention. However, we don't believe the system aligns the team's interest with that of investors as completely as one which directly reflects longer-term performance. This type of reward mechanism, which rewards growth in assets under management (and thus profit growth) can be problematic for investment houses with a limited fund range as it may encourage expansion of fund size beyond an optimum level.