Income firms need to understand where growth is emerging

In the second quarter, £25.8bn was distributed by UK companies at the headline level, compared with £25.5bn last year. While an improvement of £303m seems substantial, a 1.2 per cent rise is actually the smallest annual increase in a quarterly total since 2010.

At an underlying level, dividend growth has also tailed off, climbing by 3.2 per cent in the second quarter – the third weakest rate of growth in three-and-a-half years. As a result, we anticipate that for the full year, dividends will rise just 3.5 per cent compared with 2013.

Although equities remain more attractive than many other forms of investment, it’s crucial that investors understand what is causing the underlying slowdown in dividend growth, and which sectors are best placed to see stronger income growth.

The UK’s largest companies are at the heart of the underlying weakness. Among the top 15, which make up more than three-fifths of the UK’s total dividend distribution, eight companies saw their payouts decline, which contributed to total dividends falling by 0.8 per cent year on year.

Miners, financials, and oil and gas companies have been the hardest hit. The international nature of the biggest UK companies means they have been most affected by economic headwinds, which have reined in earnings. Equally, the rise of sterling has taken its toll.

Half of the top-15 dividend payers declare results in US dollars. These firms have not slashed dividends in dollar terms, yet slow or flat growth is resulting in an effective cut for UK investors when converted into pounds. We estimate the pound’s rise is likely to wipe roughly £3.5bn off UK investors’ income in 2014 as a whole.

Companies less dependent on global conditions, and more on the UK’s economy, performed better than their larger counterparts. Outside of the top 15, dividend growth has not been stellar by any means, but progress has been evident.

In the second quarter, dividends climbed 4.4 per cent year on year and a third of these companies saw double-digit growth. Firms exposed to the UK consumer are doing best.

Housebuilders, benefiting from a resurgent property market, have propelled payouts in the household goods and home construction sector up 8.4 per cent. Likewise, travel and leisure saw a significant upswing in payouts, rising from £459m to £692m in the quarter.

General retailers, too, have put in a strong performance, with dividends climbing by 45 per cent in the previous quarter.

However, 2015 should see a rosier picture. With the strengthening of the pound already factored into this year’s figures, it is unlikely to be such a drag next year. In fact, if it continues to climb down from this year’s highs, dividend growth will look much better for sterling investors.

Similarly, if the global economy picks up as forecast, we should see this filter into the earnings and dividends of the UK’s largest firms.

In the meantime, however, it’s all the more important that income investors understand where growth is emerging and select their companies carefully, according to the fundamentals behind picking dividend-paying stocks: foreign exchange risk, performance, long-term strategy, and dividend history.

Justin Cooper is chief executive of shareholder solutions at Capita Asset Services