Income Investors: Beware Yield Traps

It's important not to focus purely on yield when picking FTSE 100 stocks, says Lucy MacDonald, manager of Brunner Investment trust

David Brenchley 20 August, 2018 | 8:28AM
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Shell, BP, FTSE 100, Income investing, GlaxoSmithKline, dividends

Some of the most-popular FTSE 100 companies are only in investors' portfolios for their current yield. But according to Allianz’s Lucy MacDonald this strategy could be exposing your capital to unnecessary risks.

The UK is a fertile hunting ground for income seekers, with a high number of FTSE 100 stocks yielding over 4%. With UK interest rates still only at 0.75% despite recent hikes, those numbers are understandably attractive to investors.

However, those high-yield stocks are highly concentrated and their level of dividend cover remains low warns MacDonald.

Because of these risks, MacDonald, chief investment officer of global equities at Allianz, has been transitioning the Morningstar Bronze Rated Brunner Investment Trust (BUT) towards a more global portfolio.

As part of a structural and strategic change, MacDonald changed the trust’s benchmark from 60% FTSE All-Share and 40% FTSE World ex-UK, to 70% FTSE World ex-UK and 30% FTSE All-Share in March 2017.

She has been reviewing her UK holdings “to see if we can do better” after taking over as the sole-manager two years ago.

“There were some quite big, stodgy companies in the portfolio – oil companies and a couple of banks – just for their dividends,” she explains. “It’s difficult to replace something that’s got a 9% yield, but if there’s no coverage on it then that’s a problem.”

The trust is one of the Association of Investment Companies’ dividend heroes, having grown its payout annually for the past 46 years. Therefore, MacDonald wants “to make sure we’ve got good backing for the dividend growth going forward”.

Stocks on the At Risk List

The process of reviewing UK holdings is ongoing, with MacDonald suggesting some of the high yielders, including oil majors BP (BP.) and Shell (RDSB) and banks Lloyds (LLOY) and HSBC (HSBA), may eventually be dropped.

“We don’t want to buy things just for yield,” she tells Morningstar.co.uk, explaining that there must be a wider investment case in order to justify keeping in the portfolio. “The oil companies, over time, have a little bit of that yield-only characteristic,” MacDonald adds.

“They’re fine for the moment and I think they’re both delivering more or less what we’d hoped. But if your fund didn’t have that yield requirement, you wouldn’t own them. Over time we think we can do a bit better.”

Tobacco companies are a contentious sector for fund managers at present, with questions over the sector’s future prospects as smokers in the developed world transition towards low nicotine products.

It’s a sector MacDonald is shunning, despite seeing some attractions. Her team reviewed British American (BATS) and Imperial Brands (IMB), and though they found the stocks were attractively valued, they concluded there were too many headwinds.

Volume was one: “Anything where volume is falling, we’d rather not invest in – we want growth,” said MacDonald

Environmental, social and governance considerations were another.

Phama Stock Makes the Cut

One firm with a juicy yield MacDonald does like is drugmaker GlaxoSmithKline (GSK). “Historically, it just had a really good yield going for it; now we think there’s a bit more of an investment case,” she says.

That investment case is predicated on a new management team and a plan to restructure the Zovirax manufacturer. New boss Emma Walmsley is a plus, but it’s the “high-quality hire” of Hal Barron as chief science officer that is the big pull for MacDonald.

Barron has held senior positions at Genentech, Roche and Calico and is now in charge of research and development. MacDonald says: “He is already working through their pipeline to make it more efficient and focused.”

Meanwhile, his expertise in oncology, which Glaxo exited from in recent years, could signal a u-turn on that strategy. MacDonald says this would be an interesting development.

Elsewhere, the vaccines and consumer health businesses are doing well. “In time, we think all this might begin to come through in a bit more growth, which has obviously been a problem,” continues MacDonald.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk