12.10 rwc enhanced (citywire)

O C T O B E R 2 0 1 2

Generating higher income with a lower volatility equity strategy

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Nick Purves | Ian Lance | John Teahan Portfolio Managers

The team joined RWC in August 2010 to launch the income franchise

Between 4 and 16 years at Schroders – senior portfolio managers & specialist derivative trading

• Managed Schroder Income Fund from 2003 and Schroder Income Maximiser Fund from inception in 2005

• Schroder Income Fund ranked 1st (out of 57) in its sector during period under management

• Schroder Income Fund: Morningstar five star rated, OBSR AA rated, Winner of Moneywise fund awards 2009 UK Equity Income and

Equity Income and Growth

• Schroder Income Maximiser: Morningstar five star rated, OBSR A rated, Winner of Lipper Fund Awards 2010 UK Equity Income,

Winner of Trustnet 2009 UK Equity Income

• Manager of St James’s Place Equity Income Fund since 2001

• Total of £1.3bn under management

RWC Income Team

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Data to end September 2012

Total Return Annualised

SJP Equity Income Fund % 111.1% 6.5% pa

FTSE All Share Index % 52.5% 3.6% pa

Investment Performance (net of fees)

Source: RWC / Bloomberg. Data is shown for the period 29/12/2000 to 31/09/2012 net of fees. Equity index used is FTSE All share (TR). Note that Nick Purves has been responsible for the SJP Equity Income Fund since 29/12/2000 during that time he has been employed by both Schroders and RWC Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested

SJP Equity Income vs FTSE Allshare

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Investors want income…

Source: Bloomberg

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...but with less volatility

Source: Bloomberg

-50%

-50%

FTSE 100 Index

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RWC Enhanced Income Fund

Offers higher than average yield

• UK equity income fund targeting 7% yield

• Underlying fund yields 4-5%

• Yield is ‘enhanced’ through the use of covered calls

But with lower than average volatility

• High quality, lowly valued cash compounders

• Call overwriting strategy lowers volatility

• Willingness to hold cash – currently 15%

• Other methods of capital protection e.g. put spread

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How the Strategy Works

• Current underlying portfolio dividend yield of 4.4% enhanced to 7%

• Fund sells 3 month call options on each stock in the portfolio for 1% premium (x 4 quarters=4%)

• Strike price of call options is set above the level of individual stock price at the start of the quarter

• This has the effect of a cap on the growth of each stock at the end of the 3 months

• Fund receives option premium from selling the call options, which is applied to enhance income for investors

Example: Vodafone option

Vodafone share price 150p

Option Price 1% = 1.5p

3 month option

Strike level 173p = c. 115%

How do we produce the income?

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The Fund delivered a 7.2% yield on year 1 and 7.6% in year 2

Table 1: Fund Distributions

*The Yield is calculated as the summation of quarterly percentage distributions. The historic yield is equal to 7.6%. **The Retention Rate is the % of initial premium received retained against the payout on the expiry of the option contracts

Date Unit Price

(B Share Class) Distribution (£) Yield %

Dec-10 95.5 1.45 1.45%

Mar-11 94.4 1.75 1.83%

Jun-11 95.0 2.02 2.14%

Sep-11 81.9 1.66 1.75%

Dec-11 84.5 1.48 1.71%

Mar-12 87.7 1.50 1.78%

Jun-12 86.4 2.06 2.35%

Sept-12 87.3 1.43 1.67%

Delivering on the Income

Lowering volatility helps smooth the income stream

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Lowering volatility does not mean having to sacrifice return

Source: Clarke, de Silva, Thorley ‐ “Minimum Variance portfolios in the US Equity Market” 2006

3.7%

4.6%

5.7%

7.1%

8.8% 1.0% 1.0%

1.1%

1.0%

0.8%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Quintile 1(Low Volatility)

Quintile 2 Quintile 3 Quintile 4 Quintile 5(High Volatility)

Relationship between risk and return within asset classes

Monthly Standard Deviation (Risk) Average Monthly Return

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Why does this work?

Month 1 Month 2

Beta Start Value Return Value Return Value

Market 1.0 100 10% 110.0 -10% 99

Low volatility 0.5 100 5% 105.0 -5% 99.75

High volatility 2.0 100 20% 120.0 -20% 96

Source: RWC (for illustrative purposes)

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Delivering on the volatility

Source: Bloomberg, *30 day volatility for May 2012

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%YTD to end of September May-12

FTSE All Share RWC Enhanced Income Fund

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6.4

6.5

6.6

6.7

6.8

6.9

7.0

7.1

11.5 12.0 12.5 13.0 13.5 14.0 14.5

Exp

ecte

d R

etur

n (%

)

Volatility (Expected Standard Deviation (%))

Low volatility impact on asset allocation

Increased exposure to growth assets for given level of risk

Why does it matter for you?

Source: “Local Government Pensions in England” Audit Commission 2010

79% Low Volatility Equity 21% Fixed Income

60% Cap Weighted Equity 40% Fixed Income

60% Low Volatility Equity 40% Fixed Income

Reduced risk for given level of return

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Call over writing strategy reduces volatility

• In falling market, few prices go through strikes and hence premium income is retained

Willingness to hold cash

• Taking advantage of fall in share prices to buy higher yielding stocks

Ability to apply measures of downside protection

• Use index put options to reduce drawdown in weak markets

High quality, lowly valued cash compounders

• This does not mean paying ANY price for Consumer Staple stocks!

Four Steps to Lower Volatility

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Quality businesses grow intrinsic value with time…..

• For high return businesses intrinsic value grows over time; low return businesses see intrinsic value decline

• Earnings and cash tend to be stable and predictable

• Strong balance sheet further reduces volatility

Source: CSFB Holt / Bloomberg CFROI – Cash Flow Return on Investment

-5

0

5

10

15

20

25

30

35

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

%

British Airways - Historic and Predicted CFROI

CFROI Discount rate Average

-5

0

5

10

15

20

25

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

%

Next PLC - Historic and Predicted CFROI

CFROI % Discount rate Average

0

500

1000

1500

2000

2500

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Next PLC

Last Price

0100200300400500600700800

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

British Airways

Last Price

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Source: SocGen Cross Asset Research, October 2010, 2000-2010

Quality/Dividend Yield Strategy

High Dividend Yield Strategy

Return (%) 8.3 8.6

Max drawdown (%) 33.3 47.9

Beta (x) 0.6 0.9

Volatility (%) 10.5 16.9

Risk-adjusted Return (x) 0.79 0.51

Combining high quality and yield lowers volatility & improves risk adjusted returns

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But quality alone does not work

Source: Excellence Revisited M Clayman 1994

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

A+ A A- B+ B B- C/D

Annu

al A

vera

ge R

etur

ns (1

986-

94)

S&P Common Stock Rating

S&P Stock Ratings and Stock Returns

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Valuation is THE Key Determinant to Future Returns

Source: Robert Shiller, Morgan Stanley

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Key is to buy QUALITY but only when it is good VALUE

Source: RWC, for illustrative purposes only

Share price

Margin of Safety

Intrinsic Value

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And not as defensive as common perception

And today consumer staples stocks are expensive

1.8

1.9

2.0

2.1

2.2

2.3

15

25

35

45

2008 2009 2010 2011 2012

Coca-Cola

Price (LHS) BEst Standard EPS Adjusted+ 2012

3.5

4.0

4.5

5.0

5.5

6.0

40

50

60

70

80

2008 2009 2010 2011 2012

Pepsico

Price (LHS) BEst Standard EPS Adjusted+ 2012

3.5

4.0

4.5

5.0

5.5

40

50

60

70

80

2008 2009 2010 2011 2012

Procter & Gamble

Price (LHS) BEst Standard EPS Adjusted+ 2012

3.0

3.4

3.8

4.2

4.6

5.0

15

25

35

45

55

65

2008 2009 2010 2011 2012

Nestle

Price (LHS) BEst Standard EPS Adjusted 2012

Source: Bloomberg

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When growth stocks disappoint….

Source: Bloomberg

8

9

10

11

12

13

14

15

16

17

0.62

0.64

0.66

0.68

0.7

0.72

0.74S

ep-1

1

Oct

-11

Nov

-11

Dec

-11

Jan-

12

Feb-

12

Mar

-12

Apr

-12

May

-12

Jun-

12

Jul-1

2

Aug

-12

Sep

-12

Oct

-12

Burberry

BEst Standard EPS Forcast (right-hand side)Price (left-hand side)

7%

-24%

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RWC Enhanced Income Fund – Why now is a good time to consider this strategy

Offers 7% yield in a low income environment

But with lower than average volatility

• Low volatility is a good long run strategy

• Deteriorating economic fundamentals combined with high valuations make now a good time to consider defensive funds

Appendix

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Dividend growth strategies tend to be lower volatility

Source: Ned Davis Research

0

5

10

15

20

25

30

-2

0

2

4

6

8

10

Dividend Cutters Zero Dividends Dividend Stocks(No change)

Growing Dividend Stocks

Annual Compound Return Annual Standard Deviation

Annual Compound Return & Standard Deviation; Jan 1973 – Sept 2010

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and are defensive in a market decline

Source: David Dreman in Contrarian Investment Strategies: The Psychological Edge 2011 . See also ‘Do Dividends matter more in declining markets’ Fuller and Goldstein 2005

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Performance of Dividend Yield only relative to market

Performance of High Free Cash Flows & Dividend Yield relative to market

• Combining dividend yield and cash flow improves returns

Dividend yield is only part of the solution

Source: Empirical Research Associates, October 2010. Data is UK market 1987-2010

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High dividend yield can be misleading

Source: Bloomberg, Company reports, Morgan Stanley, HOLT - August 2012

Dividend Yield Free Cash Flow

Yield Financial Gearing

(Debt/EBITDA) Profitability / Return

on Capital

National Grid 5.7% 1.6% 4.2x 5.3%

SSE 5.9% -1.6% 3.3x 7.1%

United Utilities 4.5% 1.2% 6.1x 2.9%

RWE 6.3% -1.5% 3.5x 4.2%

EON 5.5% 1.1% 2.9x 4.1%

Severn Trent 4.0% 1.7% 5.2x 2.8%

Average 5.3% 0.4% 4.2x 4.4%

• Dividends paid from borrowings

• Financially weak

• Poor profitability

Example: Utility Companies

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Paying too much for quality yields poor results - GlaxoSmithKline

• Since 2000 earnings and dividends +7% p.a. whilst the shares have fallen

• In 2000, excitement about the company’s prospects resulted in a P/E of 40x

• In the next decade, the earnings doubled and the shares halved

• Today, investors are gloomy about future growth so shares priced at 12x 2012 earnings; 5.0% dividend yield

Source: Bloomberg, company report and accounts

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6%

9%

6%

4% 16%

8%

1%

14%

4% 3%

8% 1%

16%

3%

1%

Current Portfolio – RWC Enhanced Income Fund

Source: RWC, August 2012. Positions less than 2% excluded

Cash

Telecoms Deutsche Telecom 3% KPN 2% Vodafone 5%

Pharmaceuticals Astra Zeneca 4% Eli Lilly 2% GlaxoSmithKline 5% Merck & Co 2% Pfizer 2%

Industrials Smiths Group 3%

Energy BP 4% Royal Dutch Shell 4%

Retailers Next 4%

Insurance Legal and General 4% Old Mutual 3% RSA Insurance 4% Standard Life 3%

Other Financials Close Brothers 2% Provident 2%

Technology Logica 3% Microsoft 2% HP 2%

Media Daily Mail & General Trust 3% Reed Elsevier 3%

Food & Beverage Unilever 3%

Swaptions

Food Retailers Tesco 4%

Support Services

Index Put Options

Please contact us if you have any general questions or would like to discuss any of our strategies.

RWC

60 Petty France, London, SW1H 9EU Tel: +44 20 7227 6000 Fax: +44 20 7227 6003 Email: [email protected] Web: www.rwcpartners.com

RWC Contact

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RWC Risk Warnings & Disclaimers

This document contains information relating to RWC Partners Limited, RWC Focus Asset Management Limited and RWC Asset Management LLP (collectively, “RWC”), each of which is authorised and regulated in the United Kingdom by the Financial Services Authority (“FSA”), and services provided by them and may also contain information relating to certain products managed or advised by RWC (“RWC Funds”).

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

The services provided by RWC are available only for and this document is directed only at, persons that qualify as Professional Clients or Eligible Counterparties under rules of the FSA. It is not intended for distribution to and should not be relied on by any person who would qualify as a Retail Client.

In addition, although certain sub-funds of RWC Funds SICAV are recognised schemes for the purposes of Section 264 of the Financial Services and Markets Act 2000 of the United Kingdom (“FSMA”), all other RWC Funds are unregulated collective investment schemes for the purposes the FSMA, the promotion of which either in or from the United Kingdom is restricted by law. Accordingly, this document is issued and approved by RWC Limited for communication by RWC Partners only to, and is directed only at, persons reasonably believed by it to be of a kind to whom it may communicate financial promotions relating to unregulated collective investment schemes by virtue of the Financial Services and Markets Act 2000 (Promotion of Collective Investment Schemes) (Exemptions) Order 2001, as amended (the “Order”), or the Conduct of Business Rules of the FSA. Such persons include: (i) persons outside the United Kingdom; (ii) persons having professional experience of participating in unregulated collective investment schemes; and (iii) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 22 of the Order. Any unregulated collective investment schemes described herein are available only to such persons, and persons of any other description may not rely on the information in this document.

Where this document is received outside the United Kingdom, it is the responsibility of every person reading this document to satisfy himself as to the full observance of the laws of any relevant country, including obtaining any government or other consent which may be required or observing any other formality which needs to be observed in that country. Nothing in this document constitutes an offer or solicitation by anyone in any jurisdiction in which such an offer is not authorised or to any person to whom it is unlawful to make such an offer or solicitation. Interests in RWC Funds are available only in jurisdictions where their promotion and sale are permitted.

No person receiving this document may further distribute it, or copies of it, to any other person or publish any of its contents, in whole or in part, for any purpose.

This document is provided for informational purposes only. The information contained in it is subject to updating, completion, modification and amendment. RWC does not accept any liability (whether direct or indirect) arising from the reliance on or other use of the information contained in it. The information set out in this document is to the reasonable belief of RWC, reliable and accurate at the date hereof, but is subject to change without notice. In producing this document, RWC may have relied on information obtained from third parties and no representation or guarantee is made hereby with respect to the accuracy or completeness of such information. Performance figures and data analysis within this document are shown and calculated net of fees and expenses and represent the reinvestment of dividends and income. Market index information shown within this document is included to show relative market performance for the periods indicated and not as standards of comparison. Such broadly based indices are unmanaged and differ in numerous respects from the portfolio composition of RWC Funds.

This document does not constitute offer or solicitation to anyone in any jurisdiction of or to acquire interests in any RWC Fund. Investment in any RWC Fund should be considered high risk. Past performance is not a reliable indicator of future results and may not be repeated. The value of investments in RWC Funds and the income from them may fall as well as rise and may be subject to sudden and substantial falls. Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in RWC Funds after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in RWC Funds. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. There is no guarantee that the securities referred to in this document will be held by RWC Funds in the future. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document does not constitute investment, legal or tax advice.

This document expresses no views as to the suitability or appropriateness of the RWC Funds or any other investments described herein to the individual circumstances of any recipient. Potential investors in the RWC Funds should refer to the latest relevant Full Prospectus, KIID and latest Annual and Interim Reports for more information.

A United Kingdom investor may not have the right (otherwise provided under the FSA Handbook of Rules and Guidance) to cancel any agreement constituted by acceptance by or on behalf of an RWC Fund of an application for interests in an RWC Fund. In addition, most if not all of the protections provided by the United Kingdom regulatory structure will not apply to investments in an RWC Fund. Investors in an RWC Fund will not receive compensation under the Financial Services Compensation Scheme in the United Kingdom in the event that the fund is unable or likely to be unable to satisfy claims against it.

This document is issued by RWC Partners Limited, a company registered in England and Wales (No. 03517613) with its registered address at 60 Petty France, London SW1H 9EU. .

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