JP Morgan US Equity Income fund

With the presidential election just finished and the country facing some major fiscal decisions in the coming months, all investment eyes are currently on America.

For us, sell-offs create an opportunity to buy – as we have done with Apple – as we remain convinced of fundamental US strength.

Despite ongoing concerns, the US economy remains on a steady recovery path and this has translated into American equities leading performance tables in 2011 and year to date. Many UK investors remain cautious on the region however, citing arguments that few managers have been able to beat such an efficient market. In fact, several groups can boast long-term consistency in the US, with JP Morgan’s (JPM) US equity income strategy beating the market by around 2% per annum for more than a decade for example. JPM launched a version for UK investors in late 2008 and the portfolio – headed up by Clare Hart – is currently second in the peer group over three years to mid-November.US equity enthusiastsFiona Harris, a client portfolio manager who works on the fund alongside Hart, is a selfconfessed enthusiast for US equities and struggles to understand European investors’ reticence when it comes to this market. “If you look at the macro picture, the recovery is ongoing and while GDP growth is not at the 4% expected at this stage in the cycle, the 2% we have is considerably better than Europe,” she says. “The US market also includes more global powerhouse type businesses than any other and these defensive higher-quality names have driven the strong performance of the last two years.” Harris also highlights a strong corporate picture, with a fairly traditional V-shaped earnings recovery from the depths of the recession despite weaker-than-expected numbers in recent weeks. “Companies have squeezed margins as far as possible so the next leg of performance needs to come from consumers starting to spend again,” she adds. “This is largely dependent on an improvement in housing sentiment and this has clearly now troughed and signs are emerging of improving confidence.” For Harris, this has been a unique recovery in that capital spending has not increased, with many companies pausing activity while uncertainty remains. This means several businesses are sitting on piles of cash and she says AT&T’s recent announcement of a new Capex programme shows positive movement here as well. “Overall, we see these factors showing the US recovery has legs to run and therefore believe UK investors need an allocation to this part of the world,” adds Harris.Income advocatesAlongside the case for US equities in general, Harris is also positive on the increasingly popular income theme in the region, again puzzled by UK investors’ view on America as a fundamentally growth market. “If you go back as far as 1926, 43% of the total return from US equities in the period to end 2011 has come from dividends,” she says. “There have been periods when dividends fell out of fashion but they have always been there and this is not a new theme. This year should set a record high for dividends, with payouts around 16% above 2011 levels, and 400 of the S&P 500 are currently making distributions, the highest number for more than a decade.” Like most advocates of overseas income funds, she also highlights the breadth of dividend opportunities in the US, across a range of sectors, compared with the bias to a few large caps in UK products. “US companies increasingly want to reward shareholders by blending dividends with reinvesting to grow the share price,” adds Harris. “With payout ratios of around 28% against a long-run average of 40%, there is plenty of room for dividends to grow, particularly with so much cash sitting on balance sheets.”Harris remains confidence on the dividend outlook, despite growing fears the new government may as much as triple current tax rates on distributions. Prior to the Bush era, dividends were taxed as ordinary income, but since 2003 they have been treated as long-term capital gains at a rate of 15% for most investors. Obama’s proposed 2013 budget would see dividends move back into the ordinary income bracket, incurring tax over 40%. According to Harris, the key message is that any changes would not affect UK investors in US funds but a concern is how more onerous taxes would influence performance of dividend-paying stocks. “Evidence suggests little correlation between the tax regime, with dividend-paying stocks outperforming non-payers by 3% per annum from 1979- 2002, when distributions were taxed at 50- 70%,” she adds. While higher dividend taxation could make this a less popular way of rewarding shareholders, Harris says there are no signs of companies paring them back. “That said, we could well see some instances of special dividend payments in the coming months to take advantage of lower tax rates, which is good news for investors,” she adds.Durable franchisesMoving to the fund, JPM US Equity Income focuses on high-quality companies trading at a discount to their intrinsic value and offering a dividend yield of 2% or more. Harris says this dividend screen is very much the final part of the process – rather than dominating stock selection – with most of the fund’s performance coming from capital appreciation. “We are flexible on this yield discipline, not necessarily selling out immediately if a company falls below the 2% level,” she adds. “Take Wells Fargo for example – the bank’s dividend yield fell below 2% last year but when the company passed the Fed’s stress test, it immediately boosted its yield. We knew what was happening and want to remain invested in the stock long-term, so selling just based on yield would have cost our clients money.” On the quality side, Hart and team look for durable franchises offering stable earnings, with Harris citing McDonalds as an example.