In flavour

The quest for yield prompts investors to acquire a taste for equity income, the “vanilla” sector, as firms with healthy balance sheets again pay dividends to their shareholders. Helen Burnett-Nichols reports.

An “image problem” is one expression used to describe the situation that has faced equity income over the past few years, as the dividend cuts resulting from the financial crisis followed by the BP disaster affected returns and intensified the search for yield.

But with the arrival of a new year comes a positive outlook from many about the sector, with several analysts and managers expecting healthy ­dividend growth among many British companies and low interest rates to bring UK equity income back into fashion.

“Dividend investing really hasn’t been in favour for a few years now,” says Joe Wiggins, an investment manager at Principal Investment Management. As a commodities-driven market, the financial crisis and the BP oil spill led the market towards short-termism rather than a focus on the fact that dividends and dividend growth dominate total returns for equity investors over the long-term, he explains.

”Every day, we’re seeing dividends surprise on the upside”

The Investment Management Association (IMA) UK Equity Income sector fell 28.2% in 2008, before climbing 22.7% last year and ended 2010 up 14.5%. Compare this with the UK All Companies sector, for example, which slid 32% in 2008, climbed 30% in 2009 and ended 2010 with a 17.2% gain, according to Trustnet.

Although the 10-year phenomena is for equity income to outperform growth, says Gary Potter, a Thames River multi-manager, over the past five years the opposite has occurred, mainly because of the two-year performance figures.

“Part of that would, of course, be due to the banking sector cutting and removing dividends, and part of that is due to BP removing part of its dividend,” he says. (article continues below)

But despite the events of the past few years, there are signs that this has already begun to reverse. In its Dividend Monitor for the third quarter (Q3) of 2010, Capita Registrars noted that in the third quarter, dividends grew for the first time since the first quarter (Q1) of 2009, with companies such as Anglo American, Persimmon and Cape reinstating or increasing their dividends in the second half of 2010 as earnings rose.

Many managers are expecting several companies to make their return to the dividend list in 2011, such as Debenhams and Enterprise Inns. Dividends are also up for several other stocks such as Melrose, Sainsbury’s and BlueBay, says James Lowen, a co-manager of the JOHCM UK Equity Income fund.

“Every day, we’re seeing dividends surprise on the upside,” he says.

But this positive outlook follows years of bad news for equity income-seekers. For many companies, as liquidity dried up during the financial crisis, it swiftly became uneconomic to pay out a dividend, says Kevin Murphy, a co-manager of the Schroder Income fund, and so they hoarded cash. In an extraordinary event, banks, which accounted for almost 25% of income, also cut their ­dividends almost to zero overnight, he says.

“That meant that we had for the first time in many decades, a market-wide dividend cut. Peak to trough dividends fell by around 35% for the market as a whole,” he says.

Add to this another headwind facing the UK equity income sector over the past six years – the rise of the mining sector, which tends not to yield, says Lowen.

According to the Capita Registrars Dividend Monitor for Q3 2010, UK full-year dividends paid in 2010 are an estimated 5.1% lower than in 2009, which was 13% lower than 2008.

However, to a degree, this masks a much stronger position, says Lowen.

While the oil companies accounted for a large proportion of dividends in 2009, BP’s announcement in June that it was cancelling its dividend for the rest of 2010 following the Deepwater Horizon oil spill in the Gulf of Mexico resulted in a dividend cut that exceeded the entire £1.5 billion distribution of the FTSE 250 in the third quarter, according to Capita. If not for BP cancelling its dividend, the total amount returned to investors by British companies would have climbed 4% in 2010.

At the time, BP said it felt it was “prudent to take a conservative financial position given the uncertainty over the extent and timing of costs and liabilities relating to the spill.”

While some funds were able to grow their income despite the BP situation, it did have a big impact on the market dividend, say managers. In its October 2010 UK Equity Income review, Standard & Poor’s said those that benefited the most were understandably those not holding the stock at all.

Fortunately, says Richard Troue, an investment analyst at Hargreaves Lansdown, most funds took a measured approach to the BP situation, rather than simply dumping their BP stock. While some reduced their holding, others used the subsequent share price weakness to buy more, with a view that 2010’s disaster may well turn into 2011’s opportunity.

“What caused it to regress might cause it to re-appreciate as a total return concept as a stock,” Potter says.

”What caused it to regress might cause it to re-appreciate as a total return concept as a stock”

Murphy is one of those managers who recently bought more BP.

“A lot of income funds were selling BP as they cut the dividend. We bought more even though it didn’t pay a dividend. Now, the reason why is because we look for companies that have the ability to pay a dividend, we look for the ability for the cash flows to cover the dividend comfortably. And BP passed its dividends for political reasons,” he says.

While BP is expected to return to the dividend list in 2011, many ­companies have also been stepping up in the meantime to fill the dividend gap.

Capita notes that the number of companies increasing or reinstating pay-outs outnumbered those cutting or cancelling by 3:1 in Q3 2010, and managers are expecting this trend to continue in 2011 as a result of underlying balance sheet strength.

“I think the era of cuts is over. So we had all those big dividend cuts in the banks and other companies which were cyclical, and the last gasp of that was the cut by BP, which was for slightly different reasons. I would be very surprised to see further major cuts,” says Michael Clark, the manager of the Fidelity Income Plus and Fidelity Enhanced Income fund.

Tony Yousefian, the chief investment officer at OPM Fund Management and manager of the OPM Equity High Income Portfolio fund says that the average yield among the top 10 highest yielding companies in Britain in September 2009 was 4.9%. Even with the BP situation, a year later the average of the dividend for the top 10 was 5.1%.

In the third quarter of 2010, while the top 15 UK dividend payers saw their dividends fall by 4%, those outside the top 15 increased their dividends by 17%, according to Capita.

Many companies, adds Yousefian, have done massive balance sheet repair work and are much leaner and after hoarding cash as much as possible, are beginning to feel more comfortable.

“It is profits that pay dividends, it is cash flows that pay dividends and we’ve seen – despite the doomsayers out there – a very healthy rebound in profits in the UK market. The profits forecast for this year are forecast to rebound by 50% from the lows, and it’s those profits that should provide the funds to pay dividends, so dividends will begin to grow,” says Murphy.

Indeed, the quality of the companies at the moment is high, says Lowen, while valuations remain low. “An income style, normally, you’re buying stuff that has issues, yet that is fully reflected in the price. At the moment, we’re getting high-quality companies with high-quality balance sheets on low valuations. That is the perfect conditions for us,” he says.

But while BP announced in its November Q3 results that its board intends to “review future dividends with the full-year results in early 2011,” Stephen Thornber, the manager of the Threadneedle Global Equity Income fund and head of its global oil sector research team says BP could be a good example of a company taking the opportunity to rebase.

“I think some companies, depending on industries and circumstances, will use it to rebalance and so, you won’t get dividend payments as high as they were in 2007 or 2008. But I think as companies get confidence, as the economic environment improves, they will want to reward shareholders who stuck with them and will want to demonstrate that they’ve got confidence in the business,” he says.

The market forecast for dividend growth in Britain in 2011 ranges anywhere from 5% into the double digits, depending on whether BP reinstates its dividend for example, and is expected to continue to increase. In 2012, according to the European Commission, several financial institutions, including Lloyds and Royal Bank of Scotland, are allowed to re-introduce their dividends.

”We’ve found that a nice way to get income for the portfolio is to invest in companies that are similar to ones we know, but just happen to be quoted overseas”

Despite the positive outlook, there are still some risks. To a certain extent, says Troue, one concern the BP situation did serve to highlight is the concentration in the British market among the biggest dividend payers.

According to the Capita Registrars UK Dividend Monitor for Q3 2010, five companies (Vodafone, HSBC, National Grid, Royal Dutch Shell and Glaxosmithkline) paid 41% of total dividends in Britain in Q3, accounting for £7.1 billion of all dividend payments.

Murphy says the British concentration is problematic for two reasons.

“The problem is, yes, it is ­concentrated and some of it is not sustainable, which provides a large risk for some equity income managers,” he says.

While many FTSE 100 companies derive a large portion of their earnings from overseas, some UK equity income managers have also been diversifying further by increasing exposure to overseas-based companies over the past couple of years, using the 20% the IMA permits them to invest outside British equities.

The recombined IMA UK Equity Income sector (which includes funds from the former UK Equity Income and Growth sector) requires funds to invest at least 80% in British equities and intend to achieve a historic yield on the distributable income in excess of 110% of the FTSE All-Share yield over three-year rolling periods.

“If you look at the constituents of the UK index to provide that level of income, [it] requires you to invest in places that you may not want to, so the outlet valve, if you like, of overseas positions is extremely important,” says Murphy.

He has allocated more than 10% of his fund to overseas-listed stocks, which he emphasises is not a bet against Britain.

“We’ve found that a nice way to get income for the portfolio is to invest in companies that are similar to ones we know, but just happen to be quoted overseas,” he says.

At the same time, with many seeking overseas sales, this means that the unloved and cheap parts of the market are often the ones that have exposure to the British consumer.

“In many situations, the most attractive parts are ironically the ones that don’t have any overseas exposure at all,” he says.

Thornber says he is expecting ­dividend growth to be pretty similar across the world in 2011, in the range of 8 to 11%, although there is an ­element of recovery in the British growth ­numbers.

Indeed, given that the picture for equity income and dividends in Britain has improved, Yousefian says it is not as necessary to look elsewhere for dividend distribution.

”As long as the economy muddles through on a global basis than we should continue to see a decent growth in dividends”

“It is not as compelling a story as it was going back two, two and a half years ago when people were looking outside the UK because dividends were much better in Europe in particular,” he says. “They can find some good companies in the UK that would satisfy the need of any equity income manager,” he adds.

Although it was a difficult market for all managers in 2010 as things were so volatile, says Wiggins, one trend that became apparent in Principal Investment Management’s most recent White List of top performing UK equity income funds is that performance for funds focused on smaller companies or with more exposure to cyclical areas of the market is improving. This contrasts with the last few years where those focused on large cap, stable areas performed well.

“We only have 15% of the fund in small caps, but it’s absolutely critical,” he says. “It’s been a major component to our outperformance, but it also helps the dividend yield,” says Lowen.

“We see a lot of resumption of dividends and companies increasing and reinstating dividends, particularly in the area of smaller companies and cyclical areas of the market which were really hit hard through the financial crisis. So the range of opportunities for UK managers should be widening which, again, enables them to have a greater selection and not focused solely on the main, kind of bellwether dividend payers in the UK market,” says Wiggins.

But ultimately whether this trend continues in 2011 depends on the shape of the economic recovery and the headwinds that companies face.

“We’re still optimistic that we will see modest dividend growth going through 2011, maybe more if we get a better recovery, but as long as the ­economy muddles through on a global basis than we should continue to see a decent growth in dividends,” he says.

However, he explains that the possibility of a double-dip recession is still a risk in Britain, as it is hard to see what the repercussions of the government austerity measures will be in a slow growth environment.

“I don’t think the recovery is necessarily guaranteed, I think the outlook for UK consumers is perhaps not the best, so there’s a risk that the recovery might not take hold as quickly or as strongly as we’d like, so that could be a headwind for managers,” adds Troue.

Indeed, the challenge for income managers has shifted from worrying about dividend cuts to what is going to drive dividend growth in a slow period for economic growth, says Clark.

“Before the crisis the main drivers to economic growth here were financial services and housing, and both those drivers have gone,” he says.

“What I really should be thinking about increasingly is where can we get the maximum dividend growth while keeping in mind the safety issues,” he adds.

At the same time, with interest rates set to remain low, the case for equity income is compelling, say managers.

“One of the factors of the environment where growth is slow is that interest rates will have to stay low and then investors will look for yield elsewhere, and one of the places that yield can be obtained is in the good-quality equity income funds and high quality dividend-paying stocks,” says Wiggins.

On December 9, the Bank of England voted to maintain interest rates at 0.5%, where they have been since March 2009. The 10-year gilt yield was about 3.4% on January 7, while nearly half of funds listed in the UK Equity Income sector are yielding more than 4%, according to Trustnet.

“It is quite rare for the equity income yield to be more than the gilt markets. And that is the case now. And in history, that has always marked a point at which the outlook for equities and equity income is better than gilts,” and a signal to buy equity income, says Potter. Dividend yields north of inflation is also not a bad starting point, he adds.

Lowen also says that dividend yield for many of the largest stocks is more than their corporate bond yield, and dividends are growing.

While demand for global income funds will also likely begin to increase, says Troue, the outlook is good for income-seeking investors in Britain. “We are seeing a lot of demand within the sector, obviously rates on cash are very low, bond yields have been falling as well,” he says.

Potter says income, once again, deserves some attention. “I still think that UK, good old equity income in the UK – what I call vanilla ice cream – is going to be back in fashion again as we go through 2011,” he adds.