Interactive Investor

Neil Woodford: How income investors can avoid value traps

24th February 2017 10:16

Kyle Caldwell from interactive investor

Neil Woodford's new CF Woodford Income Focus fund will yield 5% when it launches next month. That's noticeably higher than most other UK equity income funds and indeed his own CF Woodford Equity Income fund, which yields 3.7%.

The higher starting yield will no doubt attract the interest of the growing army of savers who are choosing to live off their investments at retirement and in effect pay themselves an income through the returns generated by their pension portfolio.

A high dividend yield looks attractive on paper, but it should be treated with a healthy dose of scepticism. As share prices and yields have an inverse relationship, a high yield more often than not is a sign that a stock, for whatever reason, is out of favour.

Shell and BP 'liquidating themselves'

Therefore the big danger when it comes to buying shares with high dividend yields is that investors can end up unwittingly buying a value trap - a share that is in trouble and unlikely to keep its income promises.

At a press briefing on Thursday (23 February) Woodford explained the main warning signs he looks for when weighing up whether a high dividend yield is sustainable. "I don't like to see businesses that are over-distributing", says Woodford.

Woodford looks for a strong balance sheet and healthy cash flow forecasts when assessing dividend suitability

"Business that over-distribute are liquidating themselves in order to sustain dividends, and this is what Royal Dutch Shell and BP are currently doing. Both firms are selling assets and borrowing in order to sustain their dividends."

Other fund managers have warned that the two oil majors' dividends may be on borrowed time, but as far as their share prices are concerned both have enjoyed a strong run over the past year.

Royal Dutch Shell shares (yielding 6.9%) have risen 33%, while those of BP (yielding 7.2%) are up 31%.

Woodford does not have any exposure to oil, gas or mining companies in his Woodford Equity Income fund, which is partly why the fund's performance suffered in 2016.

When asked to name the attributes he looks for when assessing the sustainability of a dividend, Woodford said he looks for a strong balance sheet, adding that he also needs to be confident cash flow will be healthy in future years.

International flavour

He says his new fund will have a different look from Woodford Equity Income. The dummy portfolio he is currently running ahead of the launch of CF Woodford Income Focus has around 50 stocks; of those, he says only around 15 to 20 are held in CF Woodford Equity Income.

In addition, Woodford's new fund will not have any exposure to unlisted stocks and will have a greater international flavour. It will be listed in the Investment Association's (IA's) specialist fund sector, so will therefore will have the freedom to invest geographically wherever Woodford sees fit.

Domestically focused UK stocks had a tough 2016 following the Brexit vote, while healthcare also had a sluggish year

However, the manager said at launch that non-UK equity exposure will be less than 20% as UK equities remain his bread and butter.

Woodford says he was "disappointed" in regard to fund performance in 2016, but points out that since launch almost three years ago CF Woodford Equity Income has returned 30%, placing the fund at the top of the Investment Association's UK equity income sector.

"Performance should be held to account, but I should be judged over a three to five-year period. In 2016 the @GB:UKX:FTSE 100 had a strong year, but it was a narrow set of companies that performed well. The median stock in the index was actually down for the year," says Woodford.

Domestically focused UK stocks had a tough 2016 following the Brexit vote, he adds, while healthcare, a sector he has liked for some time, also had a sluggish year.

"From where I am sitting, having had a poor 2016, I am seeing more value in the stockmarket today than I have done in a long time. The stocks I like were in a bear market last year, so I am more bullish now than I have been for a while,' Woodford adds.

In pursuit of transparency, full disclosure of the CF Woodford Income Focus fund's portfolio and breakdown of fees will be provided on a monthly basis from the fund's launch. The 'Z' clean share class will have an ongoing charges figure of 0.65%.

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.