Long ReadJul 26 2022

Is it time to invest in UK equity income?

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Is it time to invest in UK equity income?
(Dan Kitwood/Getty Images)(Dan Kitwood/Getty Images)

As a football fan, this is the time of the year I enjoy the least – simply because there is very little football to watch.

But this year, we have had the joy of the UEFA Women’s Euros 2022, which have broken records left, right and centre.

A crowd of 68,871 turned out to watch the England Lionesses edge a 1-0 win against Austria in the opening game and, at the half-way point of the tournament, attendance records had already surpassed the total number set at the 2017 final in the Netherlands.

Thoughts are turning to who might lift the trophy, with England’s Lionesses now 7/4 favourite to win.

The transfer market is also starting to ramp up, with lots of stories connecting every team with about 100 players from all over the world.

It is when we, as football fans, are at our most selfish – because all we want are the best players, without any thought about the cost and implications to our clubs.

It is something of a 'jam today, not tomorrow' scenario. We want those five-star players at any cost. Perish the thought that a football club thinks about saving some money for a rainy day.

You could have historically made the same case for UK dividends – for which there have been plenty of rainy days in the past few years with Brexit, the strong outperformance of growth-style investing, and the Woodford debacle all hitting sentiment hard. The impact of Covid-19 has also been well documented – in 2019, dividends from the UK market were approximately £100mn, but they were severely cut as we entered the pandemic.

But the recovery has been swift, after a stellar 2021 where dividends jumped 46 per cent. Figures from Link Group show that headline dividends are now estimated to reach £92.2bn in 2022 – aided by soaring commodity and oil prices.

The figures are not back to pre-Covid levels, but there are reasons for that, one of which is the great reset (the idea of companies paying dividends at a more manageable level) to allow management to reinvest in their businesses again.

Think back to those football clubs with the hefty transfer budgets. Instead of spending all of it on players (in this case returning it all to shareholders) some of these leading dividend payers appear to be rebuilding upon slightly different foundations. 

It is with good reason. Companies may be looking to let earnings growth outpace dividend growth to re-invest in their businesses and bolster balance sheets. This was not the case pre-Covid. A bit like fans, shareholders do not always think for the long term – they want that dividend compounding now to fund their retirement.

The benefits to this new approach are slowly becoming apparent. FTSE 100 earnings cover for dividends is now expected to rise to 1.95x in 2022, rising further in 2023. It is a far cry from the figures provided pre-Covid (it was below 1.5x in 2015 and 2016).

But this is just the foundation behind the improving sentiment towards UK equity income funds – there are other reasons for optimism.

The UK being a value-tilted index has, alongside Brexit, caused UK companies to trade at historically low valuations relative to its own history and its peers across the globe. But the UK’s exposure to value sectors like financials, oil, miners, and energy has become more of a blessing in recent times as rising inflation and interest rates have favoured these sectors. Year-to-date UK equities are up 1 per cent, while global equities are down 10 per cent supporting this point.

The attraction of UK equities is not lost on markets, with corporate activity rising. As GAM UK Equity Income manager Adrian Gosden points out, these transactions range from private equity to listed corporates on other stock exchanges. They are buying UK listed companies with premiums ranging from 30 per cent to 80 per cent, bringing forward the returns investors may have hoped for over a three or five-year period.

We are also seeing a ramping up in share buybacks – examples include Barclays (£1bn), NatWest (£750mn) and BP (£4.2bn). Buybacks are rare in the UK because of the demand for dividends from investors – and it often results in share price appreciation. Buybacks reduce the denominator on which dividend per share and earnings per share are calculated. This means earnings per share and dividend per share rise.

The final point I would mention is that going down this route does not preclude you from significant growth. Old style equity income funds with a large-cap focus are no longer the only game in town, with small and mid-sized offerings also available with more of a growth element attached.

Boring is starting to look interesting again – ugly is now beautiful. Here are some funds to consider for UK Equity Income exposure:

Rathbone Income

This fund has one of the best – if not the best – track records among open-ended funds for paying dividends. Manager Carl Stick maintains a concentrated portfolio of 30-50 holdings, all of which are chosen for their high quality and visibility of earnings. Stick is somewhat of a contrarian investor, so the fund may lag while its peers ‘catch up with news’. This approach requires a strong stomach, patience, and a good degree of scepticism, which, in our view, the manager has demonstrated since taking on the fund.

Schroder Income Growth

Schroder Income Growth is a solid operator that does what it says on the tin – it is a consistent performer, targeting the shares of UK companies paying dividends that should grow faster than the rate of inflation. The trust has raised its dividend each year for the past 25 years, making it an ideal option for income seekers. It invests mainly in the UK mid and large-cap space.

LF Montanaro UK Income

Montanaro is a specialist in small and medium-sized companies and this fund is no exception. The team invests in quality growth businesses with one of the differentiators being the fund’s refusal to buy stocks listed on AIM. Managed by Guido Dacie-Lombardo, the final portfolio consists of 40-50 stocks.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre