Fund Profile: Evenlode Income

Launched in October 2009, Evenlode Income, a Money Observer Rated Fund in the UK equity income category, has benefited from one of the strongest and longest bull markets in recent history.

In the five years to 23 April the highly concentrated, mainly larger-company fund has returned 89.8% compared to 67.2% from the Investment Association's UK equity income sector, placing it seventh out of 74 funds.

This strong performance, combined with an attractive yield of 3.5%, is beginning to grab investors' attention.

Assets under management grew significantly during the past year and now totals close to £300 million.

Regular income

At first glance, you would be forgiven for being fairly unimpressed by Evenlode Income's portfolio, with its top 10 holdings almost entirely populated by well-known FTSE 100 income names including Unilever, AstraZeneca, GlaxoSmithKline and Imperial Tobacco.

This initial impression may, perhaps, be compounded by the fact that the top 10 accounts for over 50% of the fund's portfolio, which contains a grand total of just 35 stocks.

This highly concentrated, large-cap style has led many to compare managers Hugh Yarrow and Ben Peters to UK equity income veterans Neil Woodford and Nick Train, both of whom have also tended to buy big names with sticking power. However unlike the latter (particularly Train), Yarrow and Peters take less of a brand-led approach and more of a quantitative, balance sheet-led tack.

For these managers cash, or more specifically cash-flow, really is king; in order for Yarrow and Peters to even look at a company, two-thirds of its annual net-profits must be in free cash while (ideally) the other third is re-invested back into the business.

According to Yarrow, this type of operating structure means that a company is able to comfortably cover its short to medium-term dividends, while - crucially - investing back into the business to fuel future dividend growth.

"That's very much the way we approach dividend investing," says Yarrow, "We are as interested in dividend growth as in what the headline yield is today, because it's that long-term growth rate in the dividend that is going to drive your returns over a long period of time."

Interestingly, this approach effectively rules out a number of major sectors and industries from the fund, including energy firms, miners, utilities, telecoms and financials; i.e. anything with a large cost or asset base and/or a questionable balance sheet.

It also sets Evenlode Income apart from its peers, argues Peters: "This is absolutely all we do. A lot of managers say that they concentrate on cash flow, but if they have BP or Shell in their portfolios, they aren't."

Yarrow continues: "You only have to look at our active share ratio - which is 80% - to see that we're not replicating the index. We actively seek out companies that meet our investment criteria and we don't invest in any that do not."

Quality values

Alongside cash flow, valuation is also extremely important to the managers. This again seems strange considering Evenlode's largest holding is Unilever, which is currently trading on a price/earnings (p/e) ratio of around 23 times compared to an average of 16 for the FTSE 100.

However, Peters argues that valuation is not as simple as a p/e ratio. "The rhetoric on value tends to be quite shrill; we assess it in a much gentler way," he says.

On a very basic level, the managers argue that "quality" - defined as strength of balance sheet, cash flow, track record, brand strength, etc - must also be factored into valuation. On this basis, Yarrow insists that firms such as Unilever are perfectly fair value and more than able to continue to pay and grow their dividend.

Having said this, both managers admit that it is becoming harder and harder to find good investment opportunities in the UK market, and like all income managers they are advising their clients to expect much lower returns in the future.

"We have been in a very strong market now for around five years and we don't think that the future returns on offer are nearly as attractive as they were. If you're selective you can still buy good, sensible businesses on 3 to 4% yields that should be able to produce mid-single digit growth in their dividends over the medium term, but that will be with volatility," says Yarrow.

Volatility pays

Yarrow says that he would like to see a lot more volatility in the market, particularly in the medium-sized company space. The manager currently has around 30% of the portfolio in medium-sized UK companies, having upped his exposure during the sector rout of early 2014.

In particular, Yarrow and Peters took the opportunity to increase their exposure to mid-cap engineers Spectris and Weir, following some serious sentiment-driven price movements that saw Spectris in particular fall 35% from peak to trough last year.

On this note, both managers are particularly looking forward to the forthcoming general election, which they hope will present further buying opportunities in the medium-sized company space.

"We don't like to predict market movements as we are long-term investors. Instead we simply react to what the market is doing, taking opportunities where we can. No one can predict what is going to happen in the general election in May; however, it may well create some volatility that could present some good buying opportunities - that would be good for us," says Yarrow.

On what might derail the fund in the short to medium term, the managers are fairly sanguine, insisting that their cash-focused investment process is designed to withstand the worst. The only potential spanner in the works could be an unexpected rise in inflation and interest rates, but as Yarrow observes, that is an extremely left-field possibility.

Overall, Yarrow and Peters are content to quietly keep doing what they are doing. Like most managers, they would love to see the fund grow, but Yarrow is keen to stress that he wants to attract the right investors.

"If any of my friends ask about investing in the fund, my first question is: 'Is there any chance you will you need the money in the next five years?' If the answer is yes, I tell them not to bother," says Yarrow.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.