Why should income investors look to emerging markets?

Spike Hughes, of INSYNERGY Investment Management explains why...

I have always loved the equity income approach to investing. New investment techniques and approaches come and go (the latter all too frequently) but equity income investing has stood the test of time. I have heard it described as the “get rich slowly scheme”, which seems quite an apt description.

What makes equity income investing particularly appealing is that it can put long-term economic forces on the side of the investor. We often use escalators as analogies to describe inherently good or bad investment strategies. If a strategy is invested in an asset class that is in fundamental long-term decline or uses techniques that may have some short-term successes followed by an inevitable wipe out, we refer to this as “running up the down escalator”. We believe in this easily envisaged analogy. It is perfectly feasible to run up the down escalator for a while and even make some progress, but it just feels like hard work.

Going with the upward flow

In an equity income strategy, you are riding the up escalator. An investor can begin with an attractive immediate starting yield and then let economics do the rest. As the economy grows, it is likely the profits of the investee companies will grow too. Clearly, not all of the companies will show the same level of earnings growth and some will not grow at all, but within a diversified strategy this will not matter too much.

Inevitably, some of the growth will simply be nominal growth as companies raise the selling price of their products in line with inflation. Again, this hardly matters. If an equity income strategy can fully protect the capital and income for an investor against the withering impacts of inflation, that will be reason enough to adopt it.

However, history has shown us that long-term investors can enjoy some real capital and income growth too.

A solid grounding

It seems clear the success of equity income is rooted in some of the oldest investment techniques. Anyone who has read about the strategies of the true greats – the likes of Buffett, Graham, Dodd and Templeton – will know they have a common thread of not overpaying for stocks.

I have been lucky enough to spend a lot of time with Crispin Odey, the legendary stock picker who manages a highly successful fund for my firm. While none of these managers would be pigeon holed as pure equity income managers, they embrace a lot of the criteria employed in managing equity income portfolios. They typically will be looking to buy when others are selling and show great reluctance to invest in high-priced glamour stocks.

In an equity income fund, the manager cannot afford to buy too many of such stocks as it will leave him short of his yield target. Similarly, an equity income fund manager cannot afford to have too many stocks in his portfolio cutting their dividend and he will therefore be drawn toward companies with sensible long-term growth plans and solid cashflows. Thus, the equity income approach is built on a bedrock of buy low, sell high and an abundancy of free cashflows.