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Why Do Income Fund Managers Love AstraZeneca plc, British American Tobacco plc & Imperial Tobacco Group plc?

AstraZeneca (LSE: AZN), British American Tobacco (LSE: BATS) and Imperial Tobacco Group (LSE: IMT) are three of the most popular shares held by UK equity income funds. Although these shares are not the highest-yielding opportunities in the UK large cap sector, many fund managers believe these shares have better capital growth prospects than some higher yielding shares.

The vast majority of equity income funds aim to provide both income and long-term capital growth. This means they do not just invest in shares that offer above-average dividend yields, but also companies that they think will offer a reasonable level of capital growth. After all, investors should only be concerned with total returns.

AstraZeneca

Fund managers are lured to invest in pharmaceutical companies because of the positive outlook on the sector’s long-term fundamentals. Populations in rich developed countries are ageing and this will create growth in the demand for new treatments for cardiovascular disease, diabetes, cancer and mental health. In emerging markets, growing access to healthcare is developing into an additional source of growth.

AstraZeneca is often a favourite for such income funds, because of its growing presence in emerging markets. It already generates some 27% of its revenues there, and over the past year, revenues from emerging markets grew 14%. But, although Astrazeneca is doing well in emerging markets, the loss of patent protection for its blockbuster drugs, Crestor and Nexium, means earnings growth overall is much more modest.

In the first nine months of 2015, core EPS has grown just 2% to $3.32. Core EPS has fallen in the past three consecutive years, and since 2011, its annual dividend has been frozen at $2.80 per share.

But many analysts remain optimistic with the firm’s future prospects. AstraZeneca has one of the most attractive development pipelines in the sector, with some 119 projects in diabetes, cardiovascular diseases and cancer.

British American Tobacco

Along with the pharmaceutical companies, tobacco companies feature prominently in the top 10 holdings of many UK equity income funds. With limited investment needs, tobacco companies can pass a majority of their earnings to investors in the form of dividends.

British American Tobacco, in particular, has a very strong track record of delivering dividend growth. Over the past four years, its dividend has grown by a compound annual growth rate (CAGR) of 6.7%, and this year, its dividend is forecast to grow by 5.2%.

Unfortunately, earnings and revenue growth has slowed considerably in recent years, as the slide in cigarette volumes continues to accelerate. The trend in declining cigarette volumes has more than offset price increases to cause earnings and revenues to decline in recent years.

Currency headwinds will also put pressure on its financial performance this year. Underlying EPS for 2015 is expected fall by 1% to 207.2p.

Imperial Tobacco

Imperial Tobacco is currently the largest holding held by Neil Woodford’s CF Woodford Equity Income Fund, accounting for 7.88% of its entire portfolio. Despite falling revenues, Woodford has gradually been adding to his position in recent months.

This is because although volumes and revenues continues to fall, Imperial Tobacco has bucked the trend with earnings. A combination of tight cost control and growth from its US brands helped earnings to grow 19% in 2015, despite a 3.1% decline in total cigarette volumes.

Valuations are also attractive, with shares in Imperial Tobacco trading at a P/E of 16.2 and yielding 4.1%.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended AstraZeneca. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.