EquitiesNov 12 2015

Stop playing footsie with your dividends

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The UK equity income sector has grown in popularity in recent years as investors faced with low interest rates broaden their search for assets capable of generating a meaningful income stream.

The sector is highly competitive and has grown from around 50 Funds in 2005 to more than 100 today. In such a competitive sector it is important to stand out, and one way to do this is to offer a differentiated approach to income investing.

Investors are often surprised to hear that 90 per cent of all dividends in the UK come from the FTSE 100. In addition the top five dividend payers in the UK (Vodafone, Shell, HSBC, BP and Glaxo) account for 45 per cent of all UK dividends. Unsurprisingly given the significant level of income generated by the FTSE 100 (£43.5bn was paid by these five firms in 2014 alone) many of the funds within the UK equity income sector invest heavily in these names. In my view this creates a high level of dividend concentration risk for investors in the UK equity income sector.


2014 Rank*Dividend cover**Company
21.1Royal Dutch Shell
31.6HSBC Holdings

*Source: Capita UK Dividend Monitor January 2015; **Source: Bloomberg

This level of concentration risk has been magnified in recent years as high-profile dividend cuts at big dividend-paying names such as Tesco, Standard Chartered and Glencore have impacted the sector. In recent months the sell-off in commodity-based stocks in particular has also increased pressure on some of the larger dividend-paying stocks. The level of dividend cover – a measure of how many times a dividend payment is covered by company earnings – has fallen significantly over the past four years on the FTSE 100 and continues to approach one-times cover.

An alternative approach to this challenge is to focus on small and mid-capitalised companies for dividend income. There are many attractions of investing at the smaller end of the market cap scale for income, beyond just the obvious diversification benefits. If you know where to look, there are high-quality smaller cap companies with the ability to provide an attractive combination of dividend income and earnings growth.

But the primary focus remains on delivering an attractive level of income. I believe the current global economic climate is favourable for investors in UK small and mid-cap companies and have been positive on the domestic economy for some time now. The FTSE 100 remains a very international index – so investors seeking exposure to the domestic economy can often benefit from looking further down the market cap scale.

The general election has broadly been viewed as positive for UK business and triggered a noticeable increased interest in smaller quoted companies. A subsequent sell-off in commodity-based stocks and concerns surrounding slowing growth in China have impacted the large cap index fairly significantly during 2015. UK small caps, with a far stronger domestic focus, have held up well during this challenging period and in my view continue to offer a more favourable outlook.

I am particularly positive on the UK consumer, who continues to benefit from low levels of inflation, low interest rates and rising real wages. Of particular interest are companies exposed to discretionary consumer spend – selling products and services which should experience strong demand in a more affluent and confident consumer environment. Consumers are in decent shape, with more money in people’s pockets and a confidence in spending it.

Identifying appropriate companies further down the market-cap scale requires legwork: with a potential universe of more than 2,000 stocks, a methodological, bottom-up stockpicking approach is key to seeking companies that are profitable at the time of investment, have a strong balance sheet and low levels of core debt, a significant market share with high barriers to entry, a strong management team and the ability to both grow earnings and pay dividends.

Outside the large end of the market it is far more important to conduct regular meetings with the management teams of companies to get a full sense of their strength and the future outlook for performance. It is in these hidden gems we often find the greatest opportunity.

Conviviality Retail runs franchised off-licenses and convenience stores primarily under the Bargain Booze fascia. The new management team provided a wealth of experience and the franchise model reduced financial risk and offered scalable exposure to UK consumer discretionary spend.

The shares came to market on a compelling valuation of 6x earnings and an 8 per cent yield. Recently the company raised £130m in equity and £80m in debt to purchase Matthew Clarke, the UK’s largest wholesaler of alcoholic drinks. The combined entity will be a major player in the UK drinks market. Before accounting for any synergies and subsequent flow through to the bottom line and dividends (which we anticipate growing), Conviviality sits on a forward yield of 4.5 per cent and an undemanding multiple. The deal is expected to be earnings-enhancing in its first full year.

Marshalls, the UK’s leading hard landscaping manufacturer, has an extremely strong market position, which reflects the sustained investment in brand and product innovation over many years. Marshalls has recently benefited, in particular, from strong sales growth in its public sector and commercial division, which focuses on markets with high levels of current and anticipated future demand such as water management, new-build housing and rail. In my view, Marshalls is well-placed to continue to deliver earnings growth through organic initiatives, supplemented by bolt-on acquisitions in high growth markets.

Clipper Logistics is a leading provider of value-added logistics solutions and e-fulfilment to the retail sector. The shares have performed well both recently and, indeed, since coming to market in May 2014, driven by strong trading and a number of key contract wins with clients such as John Lewis, Philip Morris and Zara. I believe that Clipper will continue to benefit from an evolving multi-channel retail market in which e-fulfilment operations are increasingly being outsourced.

I believe the ability to provide a differentiated income stream to investors using a multi-cap approach has clear merits throughout the business cycle. The current market environment is providing a supportive backdrop for smaller quoted UK companies, and a focus on stocks with strong domestic earnings – and in particular a bias towards the UK consumer – provides confidence.

Furthermore, I believe pressure on dividends will persist in the large-cap space and I would not be surprised to see limited dividend growth and potentially more dividend cuts on the FTSE 100 over the coming months. This remains in contrast to the positive long-term outlook for domestically focused, higher yielding companies outside the FTSE 100.

Simon Moon is a co-manager of Unicorn UK Income Fund

*Chart source: Bloomberg 31 August 2015

Key Points

The equity income sector is highly competitive and has grown from around 50 funds in 2005 to more than 100 today

90 per cent of all dividends in the UK come from the FTSE 100

The general election has broadly been viewed as positive for UK business and triggered a noticeable increased interest in smaller quoted companies