Snapshot – Income: Investors should aim to diversify

This apparently represented a staggering 118.5 per cent increase on Q1 2013’s dividend payments.

On the face of it, such massive dividend growth seems to indicate an equity income sector in rude health. But further reading reveals more than half of this figure came via a Vodafone special dividend and 76 per cent of the total was paid by just five companies; the others being AstraZeneca, GlaxoSmithKline, BP and Royal Dutch Shell.

A look at the top holdings of many UK equity income funds will reveal significant exposure to these names, often accompanied by other large-cap defensive or value names that are synonymous with yield investing. If Capita’s findings were reflected in the yield growth of equity income funds then the net result for investors would clearly not be a bad one. But this is unlikely to be the case.

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Lately there have been reports of high profile equity income funds struggling to generate enough yield to warrant their place in the IMA’s UK Equity Income sector. Why is this?

If you strip out Vodafone’s special dividend you have a less rosy picture than Capita’s headline number suggests, with only modest income growth of 3.3 per cent and the slowest underlying dividend growth in two years. Investors in many equity income funds could find their funds’ managers struggle to maintain or grow yields significantly above inflation from here if they continue to focus on the large and mega-cap stocks that typically constitute a large part of their portfolios.

Some historically higher yielding equities have become expensive – or least unattractively priced – potentially making dividend growth challenging. Others, stocks such as Diageo, HSBC or Tesco are facing challenged or declining earnings outlooks for a variety of reasons, combining business specific and wider industry or economic factors.

Furthermore, many FTSE 100 income stalwarts derive a large part of their revenues from overseas. The twin issues of challenging trading conditions in some international markets, particularly formerly high growth emerging markets, and a strong sterling are ongoing factors that may continue to negatively affect the dividend outlook for many popular equity income shares. Capita has calculated currency movements have cost income investors £3.5bn so far in 2014.

Against this backdrop, investors who require yield may be sensible to diversify the income-producing portion of their portfolio into stocks with operational momentum, which are growing faster than expectations. These companies can often positively surprise in their ability to distribute growing levels of free cashflow to investors.

The evidence for such stocks playing an attractive role for income investors can be seen in the aggregate yield they are generating. The indicative net yield on these shares is currently 3.7 per cent, putting it at premium to the market (FTSE 350 at 3.5 per cent) and representing 23 per cent forecast dividend growth for the year compared to 7.5 per cent for the growth for the FTSE 350 this year.