Dividends shield investors from secular bear, says fund manager

(October 13, 2004) Despite a roaring return on the broad equity markets in 2003, mutual fund investors have largely shunned all categories but the income and dividend products. Has investor caution led to too much risk aversion?

One veteran of the income equity market says the out-performance of dividend and income funds has not thrown investors’ portfolios out of balance, but more likely has restored a balance that was missing through the bull market.

“I don’t think it has played out to the point that income and dividend products are over-priced,” says Bill Procter, lead manager on several of Mackenzie Financial’s conservative income funds. “I don’t see that growth stocks are ridiculously cheap today. Until that happens, this is a reasonable strategy.”

Procter thinks the market is experiencing a long-term, secular bear market, which historically last between eight and 10 years. Given that time frame, the current secular bear is only halfway through its course. While equity markets have rebounded some 40% from their lows, the major indexes still have a long way to go before recapturing the peak of the tech bubble.

“We’re a little more than half way through this long-term correction phase,” says Procter. “We’re now into a cyclical bull which could last for another 6 to 12 months. But the overriding theme is that we won’t do much from the year 2000 to 2010. In the context of that kind of market, having more income flow makes sense.”

But he says investors are still setting their sights too high, expecting returns of 8% to 10%, or even higher. A more realistic expectation would be between 6% and 10% over the next three to four years.

“Income trusts and equities are about the only vehicles that can give you this 8-10% return, but you’re not being paid to take the big risks,” he says. “Your best strategy is a defensive equity portfolio with more emphasis on yield than it had in the past. You try to ride out the market and position yourself for the next big bull market.”

Procter says the interest rate bias is “up,” especially on short-term rates, but he says there may not be a major move in credit for a while.

“What would concern me would be at some point, and it could be a year or two away, when inflation finally kicks in, in part because companies that have been able to absorb cost increases through productivity gains are finding it more and more difficult to do so.”

Large increases in commodity prices would make it tougher for manufacturers to absorb the costs, which they will pass on to the consumer. Eventually, there will be upward wage pressure and inflation could become a problem, Procter believes.

“It doesn’t look like it will be an issue for another year or so, but two or three years out, that would be my concern,” he adds.

The upside bias on inflation leaves Procter skeptical of fixed income instruments, so he would allocate a low percentage of the portfolio to bonds. He sees no compelling reason to prefer short-term bonds over long, suggesting a balance between them.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com