UK income funds remain under pressure, too. With the FTSE All-Share yielding 3.7 per cent in 2015, the target yield level for funds was 4.1 per cent, and a number have fallen short.
‘Rules is rules’, but the case for a rethink on this issue in particular is pretty strong. The dividend cover for the FTSE 350 fell to a six-year low last year, with our largest companies, in particular, feeling the pressure. Not good news when they include most of the big dividend payers.
Indeed, dividend growth for FTSE 100 companies is expected to be negative this year at -1 per cent. However, mid- and small-cap dividend cover is in much better shape. Yields in most cases aren’t as high, but the outlook for dividend growth is better.
But do I want fund managers buying companies just to satisfy a yield criteria? Looking at the 39 sub-sectors of the FTSE All-Share, 15 are paying an average dividend yield of more than 4.1 per cent, so there is some choice.
However, the highest are the miners at 10.9 per cent, followed by oil and gas producers at 7.3 per cent. That’s a pretty contrarian selection.
Financials and utilities are up there, too, but the percentage of stocks offering a premium yield is at its lowest level since the 1980s – and is very much skewed towards the mega caps, some of which are paying dividends from debt rather than cashflow.
So the answer is no, I don’t want my UK equity income manager chasing yield. Given the sector is the core of many portfolios, I want the manager to be finding good companies that are going to be tomorrow’s dividend winners.
One fund in this sector I really like is Royal London UK Equity Income. I’ll state up front that the current yield is 3.4 per cent, but as I’ve said, I’ll pick robust dividend growth process over yield any day. It’s run by Martin Cholwill, who has a clear focus on cashflow and a company’s ability to cover its dividends.
His mantra is that in a world of anaemic growth, you need companies that don’t just pay a decent yield but have the ability to grow it. Over the course of a decade in charge of the fund he has created a durable and leading equity-income franchise.
It’s a high-conviction fund, and the risk profile reflects this – it’s slightly more volatile relative to its peers. It has, however, excelled on a risk-adjusted basis.
Martin has a pragmatic approach, building a portfolio suitable for all market conditions by prioritising companies with robust balance sheets, yet whose shares are sufficiently out of favour that they can be bought on a dividend-yield premium. There will be some contrarian plays, but they won’t dominate.
The fund currently has about 45 per cent exposure to mid caps and 5 per cent to small caps, but overall is size agnostic. Where the manager is invested in the bigger companies, he’s being very selective and picking the few with sustainable dividends rather than the high yielders.
Current themes in the portfolio include survivor bias – companies that can take advantage of competitors losing market share – and international earnings, on the back of sterling weakness.
Darius McDermott is managing director of FundCalibre
