InvestmentsSep 11 2020

UK market is still attractive

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
UK market is still attractive
Luke MacGregor/Bloomberg

Investing in equities for income should be as relevant now as ever.

Our population is ageing and in need of income in retirement.

Alternative sources such as bank deposits or bonds offer next-to-nothing in this period of persistently low base rate environment.

It has always been my view that equity income should aim to deliver a defensive total return for investors, placing emphasis on a growing and resilient capital return, complemented by a progressive income component.

Logically, the equities most likely to deliver this are cash-generative, growing businesses bestowed with compelling economics. 

So why have UK equity income returns lagged recently, and how do we best position investors for the future?

The challenge for UK dividends

The composition of the UK market has long been problematic. The FTSE All Share Index has been dominated for decades by a relatively small number of large businesses, some with lousy economics.

They have proven to be cyclical, hugely capital intensive and often failed to grow.

Worse still, from an income perspective, in desperately striving to provide some return to investors, many have fallen into the trap of paying unsustainable dividends such that their contribution to the overall market’s dividend became disproportionate.

Key points

  • Equity income is more important than ever
  • Many companies have been paying unsustainable dividends; while Covid-19 caused other companies to cut dividends or suspend them
  • It is important to consider sustainable growth of a stock

We estimated, heading into 2020, approximately 50 per cent of the UK market’s collective income was projected to come from just 10 companies, many of whom had clear vulnerabilities to their business models.

The Covid-19 pandemic has brought a swift and brutal reckoning for UK dividends, but the ingredients for dividend cuts were long in the making.

Alarming as this backdrop may be, I hold out hope that a more prudent approach to dividends will be taken by companies and shareholders, to the benefit of total return. I believe three factors will be key in delivering attractive equity income returns in the future.

• Investing in UK companies, not the index.

We must be careful not to confuse dynamics impacting the market-cap weighted index with UK companies as a whole. The UK remains a significant market globally.

It has strong corporate governance standards, fast-developing environmental, social and governance credentials and, most importantly, a number of high-quality businesses worthy of investors’ capital.

As professional investors scour the world, they find the UK to be home to a select group of businesses that possess the characteristics that many look for; high returns on capital, expanding end markets and powerful intangible assets that are hard to replicate.

World-class companies can be found in areas including consumer goods, speciality industrial and data/software for instance. The fact that the UK has some very large companies lacking these traits is not overly relevant, in my opinion.

It is better to eschew investments in companies that do not fit the criteria, no matter their position within the index. Investors should look beyond, rather than be beholden to, the skewed index.

• Avoiding yield traps.

In a similar vein, investors selecting income-generating equities frequently place far too much emphasis on current dividend yield. High yield is often a trap that reflects the market’s well-founded scepticism about the advertised income stream.

Yield alone should never define an income stock, and there is a very real trade-off between yield on the one hand and sustainable growth on the other.

Often-favoured investments have relatively modest initial yields, but this is combined with a demonstrable capacity to sustain and grow their distributions to shareholders.

Such growth produces a fast-growing cash income stream, which, when held for sufficient time, can outstrip the higher initial yield offered by static companies.

• Emphasising free cash flow.

Sustainable dividends are funded from excess cash flows.

Some fund managers therefore search for companies with an ability to grow free cash flow and maintain this over a very long period of time. 

We consider growing free cash flow to be the long-term source of equity value creation and what funds a dividend. Accumulating debt to pay dividends is not sustainable and eats into equity value.

Businesses that can consistently grow while earning attractive returns on invested capital will naturally generate an abundance of free cash flow.

In order to do this, they must have a clear runway for growth and possess assets – powerful brands or high switching costs, for example – that enable sustainably high returns to be earned. A growing free cash flow stream provides tremendous flexibility for companies.

They can either reinvest for further growth, distribute cash back to investors, pay down debt or simply accumulate cash for later use.

By contrast, low-returning businesses with limited growth prospects will always struggle to grow free cash flow, and therefore equity value or income.

The latter group of companies is best avoided, irrespective of the advertised dividend yield, in favour of free cash flow growers.

The long-term opportunity

Given the extraordinarily low interest rate environment, it has seldom been more important for investors to consider the trade-off between sustainable growth and yield.

In our view, the appropriate yield at any point in time is the one that results from investing in those businesses capable of growing their free cash flow and dividend over the long term.

Reassuringly, in spite of the impression that the weighted index can give, we find ample opportunity for such investments in the UK.

Blake Hutchins is a senior fund manager at Troy Asset Management