US equities: time to diversify

Fran Radano, Manager, The North American Income Trust

• The ‘Magnificent Seven’ has dwindled to just two stocks
• Investors need to ensure their US equity exposure is diversified
• The new economic environment requires greater caution

Investors may need to rethink their approach to the US stock market. After a decade where a handful of technology companies have done the heavy-lifting on returns, a portfolio shaped around these giants may not be appropriate for the environment today. Investing in quality companies, with consistent income and growth characteristics is one option for investors looking to diversify.

Seven stocks dominated in 2023 – Nvidia, Tesla, Microsoft, Apple, Alphabet, Meta and Amazon. Each had a claim to be a potential winner from the Artificial Intelligence revolution, even if it was not yet clear which would translate an exciting idea into real-world revenues. However, by the start of this year, two stocks were pulling away – Nvidia and Meta – while the remainder were either delivering index-like returns or, in the case of Tesla and Apple, significantly underperforming.

This shows that fashionable acronyms aren’t very helpful if a company is not delivering against expectations. Markets are becoming more discerning, and focused more forensically on fundamentals. This is a reflection of a changed economic backdrop: interest rates are higher and are unlikely to move back to the lows seen in the 2010s, while inflation is also likely to remain structurally higher. If low interest rates flattered growth strategies, this is an environment likely to favour different approaches. The one that has worked so well over the last decade is likely to be inadequate for this new reality.

Caution is needed

While US economic growth figures have continued to show strength, there are signs of fragility. Employment is at all time highs, and at the margins, companies are starting to announce layoffs. Strong employment has sustained consumer spending, even as the savings buffer has started to drop. If it starts to waver, it could weaken economic growth.

There are still intractable areas of inflation. The most recent CPI data showed energy and shelter costs rising, while areas such as car insurance have also proved persistently high. It is clear that the last mile on pushing inflation back to 2% may be trickier. There is often a ‘second wave’ of inflation and the US Federal Reserve is likely to be cautious on rate cuts until it has a full picture.

The market is currently pricing in a relatively bullish scenario, which sees both rates come down and economic growth accelerate. The probability of a ‘hard landing’ has not been largely discounted. We believe some caution is warranted and prices in some parts of the market have over-reached. This argues for a more defensive tilt to a US equities portfolio than investors have taken more recently.

A potential rotation

The US is known as a growth market, but this is a relatively recent development. The past decade has seen dividends fall as a percentage of total returns, but this is an anomaly produced by low interest rates. In the long term, dividends matter. The contribution of dividends to total return has been anywhere between one-third and 50%. We believe traditional dividend-paying companies will revert to become more important in an environment of higher interest rates and inflation.

Valuations in this part of the market are low relative to history. For The North American Income Trust, we are looking to buy the best quality companies at fair prices. These will not be the highest flyers, but neither will they have many of the associated risks of the fastest growth companies. We want companies that will grow consistently over time, compounding returns to investors. We only hold 35-40 companies, as we only focus on companies that will provide the best reward.

Crucially, these companies are to be found in a range of sectors, not simply in traditional ‘income’ areas, such as utilities, real estate and telcos. That allows us to build well-diversified portfolios and find value across the market.

A sign of quality

We also find that dividends are increasingly a badge of quality for companies. In markets focused on growth, paying a dividend can be seen as a sign that the company can’t find growth opportunities. That is not the case today. We find that the companies in our portfolio can pay a dividend and invest strategically in their business.

It can also be a sign of discipline. It shows that companies are not chasing every incremental project, but are focusing on appropriate capital allocation. It shows that they have strong balance sheets and cash flows.

We believe that the type of defensive, cash generative, dividend paying companies that we hold are likely to be valued by investors at a time of uncertainty. The US election later in the year adds another dimension to US markets. While we don’t believe either outcome will make a significant difference in the longer term, it has the potential to create some short-term noise.

There are reasons for caution in US markets today. Investors need to ensure their US equity exposure is balanced, and appropriate for the current economic environment, rather than the one that has just finished. High quality income-generative companies have an important role in portfolios from here.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

Find out more at www.northamericanincome.co.uk or by registering for updates. You can also follow us on X and LinkedIn.

Investment objective 

To provide investors with above average dividend income and long term capital growth through active management of a portfolio consisting predominantly of S&P 500 US equities.

Source: abrdn Investments Limited, Lipper and Morningstar. Past performance is not a guide to future results.