The search for income

Sonja Schemmann, income specialist and fund manager of the Schroder European Equity Yield Fund, shares the case for a high-dividend yielding strategy, and why Europe is especially attractive from a yield perspective.

There should always be a place for dividend strategies in investors' portfolios -- they are a lower risk means of generating steady returns in the long term. It is also a particularly good time now to invest in highyielding equities companies with regular income flows and stable growth profiles are likely to outperform in what we expect to be an environment of slowing earnings growth going forward.

The most attractive dividend strategy from a risk-return point of view is an active-managed fund approach which looks for a diversifi ed exposure to companies that, in addition to paying out high dividends, also have attractive business models and superior earnings growth.

The medium term outlook for markets provides a strong case for a dividend strategy. While valuations do not look too stretched and equities remain an attractive option, particularly relative to bonds, the market is not as cheap as it was two or three years ago. We saw significant growth in earnings per share in Europe between 2004 and 2006, much of which was initially driven by restructuring and tighter control of costs, not top-line growth. Looking ahead, earnings momentum may slow, and hence companies with stable and sustainable growth profi les and regular income streams are likely to outperform.

The improved financial health of companies in Europe is also positive. Balance sheets are in good shape, a lot of debt has been repaid and free cashfl ow levels are high. Management teams now have cash to spend either on investing in their business, making acquisitions or returning cash to shareholders.

Companies that have a policy of combining these options using cash for acquisition and reinvestment as much as for returning money to shareholders will secure future growth and, therefore, future dividend payments. A high dividend payout can instil a sense of capital discipline in companies and is a sign of quality. Investors can have greater confi dence in a management team that is prepared to return surplus cash to shareholders rather than spend it on risky acquisitions or investments. For when management does decide to spend cash on investments, they are likely to be doing so to underpin rather than dilute earnings. This should lead to greater earnings and share price growth over time and permit future dividend increases.

We think the best strategy to adopt is one that looks, above all, for companies that strike a healthy balance between the amount they pay out to shareholders and how much they spend on investment and/or acquisitions. We try to identify companies that, in addition to providing a high and stable income, also have strong growth potential as a result of attractive business models and sensible investment plans.

From a long-term perspective, investors should always consider exposure to income securities. High yielding stocks (if carefully analysed and chosen) offer stable and sustainable returns over time, about 50% of equity investment returns are derived from dividends. The risk profi le and hence volatility of dividend funds is lower than comparable benchmarks, while the average turnover of high-yielding stocks is only half that of nondividend paying stocks.

The lower volatility of dividend-paying stocks is not only related to their ability to provide a regular income stream; a reasonable dividend payout can instil a sense of capital discipline in companies and is a sign of quality and stability. As a result of this lower risk profi le and lower volatility, yield investments help improve the overall risk/return profi le of the equity proportion of any portfolio and are an ideal complement to higher risk assets such as Asian or emerging markets equities.

The best way to gain full exposure at a low risk to quality, high-yielding stocks in Europe is through a diversifi ed managed fund. Investing directly in individual securities carries much higher risks and also costs than investing in an equity yield fund. A typical equity yield fund may contain on average 60 stocks, all of which have been selected by a specialist fund manager and, in most cases, a team of analysts with indepth knowledge of industries and sectors ? the benefits of diversifi cation are clear. Even the most sophisticated private investor will fi nd it hard to generate better returns at lower risk through direct investment in individual securities. A professionally-managed fund is also more likely to find opportunities beyond traditionally high-yielding sectors like utilities and fi nancials. A refocusing on shareholder returns over the last few years has prompted companies across all sectors of the European equity market to re-think their use of cash. It is now possible to gain exposure to high yielding stocks from a range of industries to ensure broad diversifi cation within a fund. Managed funds can also offer more sophisticated dividend strategy approaches. We favour an approach that combines growth and yield, looking for exposure to attractive business models and superior earnings growth, at the same time as a regular income stream.

Investors looking to tap into a high-dividend yielding strategy can also look at the Schroder Asian Equity Yield Fund, which invests into companies which pay out high dividends in Asia. Both the Schroder European Equity Yield Fund and the Schroder Asian Equity Yield Fund will pay out 4 cents per unit for June 2007. This translates into an additional 2 cents per unit; both funds currently pay out 2 cents per unit every six months.