LONDON, 22 September 2003 — A hoary old cliche best describes how battle-scarred investors are feeling just now. ‘Once bitten, twice shy.’ And it’s a mood that several fund managers who focus on value-investing are tuned into.

They argue that the smaller companies in the UK and Europe which have led the market rally since March have little more to offer investors without a stronger economic recovery.

In their view, the best returns will now come from equity investments that focus on cash generation and dividend yield. And to judge from the growing number of cash-rich companies that have been raising their dividends of late, captains of industry have taken to heart the shareholder thirst for income as a key component of total return.

“What you see now is more European companies moving toward dividend as a way of recompensing shareholders,” says Scott McKenzie, fund manager for Morley Fund Management’s Norwich UK Equity Income Fund, part of Aviva PLC.

Equity investing remains “ultimately about company earnings,” he says, but dividend-paying shares “give you more protection in a bear market.”

That truth may have special resonance with investors in European equities over the past three years.

They’re still smarting from a decline in equity valuations that outpaced even the huge losses on NASDAQ and the New York Stock Exchange.

And while UK investors have long been disciples of the dividend culture, only now is this aspect of investing being broadly embraced within Europe, where investors are taking account of historically low yields on government bonds, the budget deficit concerns and the prospect of rising interest rates.

German and UK 10-year government bonds are currently yielding around 4.15 percent and 4.60 percent, respectively, while some equity income funds can earn nearly that much just from their stock dividends before capital growth.

Whether they’re bulls or bears, most value-oriented fund managers agree that the next stage of the rally will come from sectors that have underperformed since March. “The easy high-beta play is played out,” says Kate Cornish-Bowden of Morgan Stanley Investment Management, referring to volatile stocks which offer high return but also high risk.

When the rally began in March, Cornish-Bowden, lead portfolio manager for Morgan Stanley Investment Management’s core funds, had her three portfolios of global, European and UK stocks tilted towards these smaller, cyclical growth stocks.

But, she says, “many valuations are now fully discounting a recovery in the consumer sector” and she doesn’t see how a rally can be sustained “without a recovery in consumer demand.” More broadly, Cornish-Bowden believes a secular bull market is underway. Accordingly, she’s now looking to higher quality stocks with the ability to generate cash as a hedge against any pullback.

Sectors such as pharmaceuticals, tobacco, consumer staples and even telecommunications qualify, having all underperformed the recent rally.

Among her overweights are pharmaceuticals giant GlaxoSmithKline PLC, Allied Domecq PLC, foods conglomerate Nestle SA, household products giant Unilever PLC and mobile phone company Vodafone PLC.

Mark Lyttleton, fund manager for UK, UK Blue Chip and UK Dynamic Funds for Merrill Lynch Investment Managers (MLIM), looks to many of these same sectors for outperformance and cash generation.

“We’re looking at total return, but also to ensure there’s still some retained earnings at the end of the day” to support future investment and dividends to shareholders, he said.

That’s one reason why MLIM cut its holdings in insurers Aviva PLC and Prudential PLC, both of which were forced to cut their dividends this year.

It’s logical to take this strategy one step further by seeking out companies with the potential and the desire to raise their dividends.

MLIM has identified UK homebuilders as a prime example, offering strong earnings growth and one of the highest levels of dividend cover anywhere. Following spectacularly strong first-half results, many of the biggest homebuilders in the UK raised their interim dividends by 20 percent and more.

And with dividend covers averaging more than four times earnings per share, says Lyttleton, “there’s plenty of scope to further raise their dividends.”

Among Merrill’s holdings in this sector are Berkeley Group PLC, Redrow PLC and Wilson Connolly PLC, which agreed this month to be acquired by Taylor Woodrow PLC.

The increasing appetite for dividend in Europe isn’t without parallel in the US, where the Republican-controlled Congress recently approved legislation to end the so-called double-taxation of corporate dividends. But even without such fiscal incentives, demand has been unprecedented.

The ABN Amro High Income Equity Fund, which was launched on Sept. 1, has raised more than 180 million euros from Dutch investors just halfway through its offering period, making it the bank’s most successful equity fund introduction since 1997.

“I believe there are a lot of risk-averse investors out there” who want to hold equities offering maximum yield and minimum risk, says the fund’s manager, Wouter Weijand.