The current UK environment of low growth and low inflation has seen a drift towards stocks providing higher levels of income. Set that against other asset classes where returns are low, the attractions of the segment are plain to see. But is now the time to take profits and move on?
I think not, as investors like dividends because they provide a tangible return. Management of the dividend is inherently tied in to capital allocation decisions, cash characteristics and confidence on prospects. Providing the dividend payment is supported by an appropriate capital structure and cover ratios – earnings and cash – it gives strong confirmation of management thoughts on outlook.
A progressive dividend policy is something those at Tilney particularly target.
Dividend growth, averaging 5 per cent over the period, has outpaced earnings since the turn of the century with earnings cover still averaging about 1.5 times – a healthy level. Special dividends have come back in favour with a preference for returning excess cash rather than attempting a diversion to existing group strategy.
This in part has been driven by the impact of profit warnings where companies that disappoint see a far more severe share price reaction than was the case 10 years ago. This feeds directly into the reputation and, therefore, the ability to sell individual investment managers or their firms’ performance record.
Key points
- Dividend growth has outpaced earnings since the turn of the century.
- Investors like to see recognisable household names, offerings and brands.
- The three largest constituents all yield above 5 per cent.
Another factor behind the strength of the equity income segment has been the lack of new issues coming to the market. This, I believe, has reduced portfolio churn with investors preferring safety and certainty over trying to bottom fish established out-of-favour stocks. Corporate activity and consolidation remain features, but the voids need to be filled.
The five-year average dividend yield for the top 100 UK stocks has been 3.7 per cent while the higher yielding pot has been 4.8 per cent. Clearly an average will include both a blend of the constituents' yield along with how the overall index has performed.
Stock and sector rotation has seen many of the larger dividend sectors move in and out of favour in recent years. It is probably fair to say that post credit crunch investors sought the safety of the larger, globally diversified consumer staples.
This has seen this stock grouping become sharply rerated and looking less attractive on simple earnings and dividend-based valuations than it has for years. These stocks have also reflected the low interest rate backdrop that has prevailed in recent times. As a broad generalisation, these stocks retain growth opportunities due to increasing globalisation and social mobility. This is supported by the interest Kraft showed in Unilever and the price Reckitt Benckiser achieved for its foods business. One must not, therefore, forget the impact of compound growth on the potential returns for investors with longer term horizons.
In the private client and wealth management sector, investors like to see recognisable household names, offerings and brands, providing the potential for ratings to stay stronger for longer.
The current climate is now one of rising interest rates. With its interest rate sensitivity, Tilney has a positive stance on financials. Overall, this represents about 21 per cent by market capitalisation and includes a number of the larger, liquid, household name investments. UK banks are about 12 per cent of the UK market with HSBC a key constituent.
I see HSBC as a particular beneficiary of rising international rates. Its valuation is not demanding and has scope for further outperformance. I have been impressed by the actions taken by Lloyds Bank to resolve its legacy issues ahead of its peers.
Lloyds will be a beneficiary of rising UK interest rates and offers an attractive 6 per cent dividend yield with growth of 10 per cent in consensus expectations. The shares are trading at 1.1 times book value, which does not full reflect its capital ratio and returns profile.
The insurance sector, which has an element of index gearing, benefits from stronger equity markets. That said, there are a range of opportunities across the sector, along with above-average dividend yields.
Aviva is making good progress on portfolio rationalisation while offering a 5.2 per cent yield; Legal & General has a strong, largely domestically focused business and offers a 6 per cent yield.
The oil sector has been under a cloud for a while due to a range-bound oil price. Recent geopolitical tensions and natural weather events have prompted a recovery in share prices. While not overly bullish on the oil price as a house, Tilney likes the above 6 per cent dividend yields offered by BP and Shell.
Before dinner parties were dominated by social media, status updates and videos of cats dressed as penguins, the housing market was the prime topic. That said, investor sentiment still swings around on the housebuilders.
From a fundamental viewpoint of not enough supply and plenty of demand, Tilney stays positive on the sector prospects. The balance sheets have been sorted and there are clear strategies focused on progressive dividends and returning excess cash, making these exciting investment opportunities.
The three largest constituents all yield above 5 per cent while the smaller Crest Nicholson offers 6 per cent. A variation on the theme would be Galliford Try, which offers a 7 per cent yield. Granted it has had some contracting issues, but unlike its peers, it looks to have capped them quickly. The company has a clear plan to grow its housing margins, expand its partnerships offering and be selective in construction.
The trend towards greater digitisation and connectivity continues to provide a healthy medium-term outlook for the telecoms sector. Some investors are understandably twitchy about BT, following its Italian issues and slower UK spend, but with its strong local presence and established infrastructure, I see potential for better times ahead.
In the same vein Vodafone still has enough growth ahead of it to suggest it has not fallen into utility offering just yet. Both BT and Vodafone offer about 6 per cent yields. Slightly more left-field on this theme is Dixons Carphone, which remains one of the few places to actually handle some tech before buying it. The recent update and adjustment to forecasts was disappointing, but I sense the bar has been set deliberately low.
Finally, a few random ideas on stocks with good yields. The ability to deliver strong media content will help drive advertising revenue plus the impending arrival of a highly regarded chief executive bodes well for ITV.
The shares have also previously been buoyed by takeover speculation. Retail is a very tough place, but through its Directory, Next has demonstrated it can grow a multi-channel business. It appears to be getting its clothing staples right and trades on an attractive earnings valuation.
City congestion, pollution concerns and road charging should suggest that public transport operators have a place in the market. Go Ahead is another stock that has had issues, but still increased its full-year dividend by 6 per cent and the forecast payment is covered 1.8 times by earnings.
To conclude, while there is less obvious value in globally diversified companies, there are still opportunities available to investors. Granted these are more domestically focused, but companies that can offer an above average yield, even in potentially uncertain post-Brexit times, will attract investor interest. Look in the right place and you will find enough good opportunities.
Andy Brown is head of equity research at Tilney
