Behind the numbers: Can equity income deliver?

Patrick Enright

The ability for fund managers to generate income is becoming more and more difficult in the current economic climate. Yields are being compressed as equity valuations creep ever higher, meaning that earnings struggle to keep pace with valuations. As such, it could be argued that equity income funds are not the steadfast investments that they once were, despite their relative safety in comparison with small and medium cap funds.

Fund managers of equity income funds are having their stock picking skills tested by a number of salient issues at the moment. From a global perspective, loose monetary policy has contributed to a strong bull market, meaning that capital growth is depleting overall yield figures. Add to that the low inflation environment which we are currently a part of and maintaining high yields, let alone increasing them, is becoming increasingly difficult.

The implications of a rate rise by either the Federal Reserve in the US or the Bank of England in the UK are also unlikely to be welcomed by equity income managers. As financial markets adjust to an increase in interest rates, there is likely to be an increase in portfolio volatility for investors on the whole.

On a more domestic level, the pension reforms of April 2015 put equity income managers under the spotlight even more, as greater pension freedoms for retirees have by and large replaced the guarantor system of an insurance-based annuity for life. The UK has an ageing population who will all most likely require some form of income into their retirement so the question is, how can the reach for yield be maintained?

With these pressures in mind, traditional sources of income such as government bonds have seen their yields decline significantly. On what is considered to be the safest of European sovereign debt, the 10-year German Bund has a yield figure that is perilously close to zero despite rebounding recently. Fixed income investors have therefore felt the full weight of the credit market bubble and this problem has been exacerbated further by the European Central Bank’s €1.1tn bond-buying programme. This has forced those prudent investors who usually would hold onto long-dated treasuries for income, to dip into steady defensive stocks to seek higher yields.

However, this transition into cheap, good-quality stocks that were readily available only a few years ago, are difficult to find today. Many equity income funds will have a high exposure to the large cap blue-chip stocks of BP, Shell, GlaxoSmithKline and Vodafone. These four companies are a favourite for yield hunters, but there are concerns regarding the sustainability of their dividend payments, especially given that these four stalwarts provide an average of 30 per cent of total income for most UK pension funds.

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Pharmaceutical giant Glaxo pays an annual yield of 5.69 per cent and the firm has managed to increase its dividend over the past 12 months despite the struggling share price over that time. This is part of an overall trend whereby payout ratios in the UK market, which represent the percentage of company profits paid out as dividends, have actually increased from 35 per cent to 65 per cent within the past few years. This means that dividend cover – the number of times a company’s dividends are covered by profits, is falling. There remains a natural ceiling as to how much further the payout ratio can go as the risks of sustaining current dividend levels look to be growing. To highlight this point, consider the case of Tesco, which cut its dividend by 75 per cent in August 2014 on the back of numerous profit warnings.

To make matters worse, funds in the IA UK Equity Income sector are bound by its absurd rule that members must yield at least 120 per cent of the FTSE All-Share yield. This further restricts managers’ ability to search for a sustainable yield and increases concentration in the few big dividend payers. One fund that appears to have found a way round this is the Royal London UK Equity Income fund. It still has a yield target, so unsurprisingly the fund’s top holdings include high yielding large caps such as HSBC, Aviva and AstraZeneca, to name a few, which are well known as defensive stocks with a good track record for dividend payouts. The manager, Martin Cholwill, has retained the large-cap focus of the fund, which has meant that the largest holdings have steadily increased their weightings in the fund since the turn of the year as valuations continue their upwards climb.

Nevertheless, Cholwill maintains that 50 per cent of the fund is allocated to shares held outside the FTSE 100. Favourites include retail caterers Booker Group and the Restaurant Group, who have both seen profits remain resilient to the wider economic challenges facing more cyclical stocks such as oil and mining companies. One example of such a holding is mining giant Rio Tinto, which has been particularly vulnerable to the fallout from the six-month collapse in oil price, and so has drastically cut its production costs since last July. Despite this, the management are bullish about future dividend growth, which should bode well for managers like Cholwill.

If fund managers are to continue generating dividend growth there has to be a dynamic shift in the way that the IA UK Equity Income sector is defined. The problem facing equity income managers at the moment is the sector’s rigidity, whereby only those funds that have a yield in excess of 110 per cent of the FTSE All Share over a rolling three-year period are included. No provisions are therefore made for long-term consistency of dividend payments, nor whether the fund is actually successfully growing its dividend. As such, the difficulty of meeting yield targets and maintaining sector status could legitimise fund managers to take more risk in their portfolios.

This is evident with the Schroder Income Maximiser fund, whereby the manager has offset the risk of future dividend cuts by using derivatives to boost the income it pays, allowing the fund to preserve a yield target of 7 per cent. Nevertheless, such a common scenario has fashioned an argument for managers to focus on a total return approach instead, as opposed to the current status quo.

Among those funds that do embody a total return approach is M&G Global Dividend, which is the largest global equity income fund by size and already sits outside the IA Global Equity sector. M&G states categorically that the portfolio’s total return focus is not to be compared to high yielding strategies. Interestingly enough, in the three years to May 2015 the fund has underperformed its IA Global Total Return sector by as much as 16 per cent, as the manager has made bought distressed stocks in the portfolio today which have major potential in the future.

Another recognised fund that has chosen to ignore such sector parameters is the Invesco Perpetual Income and Growth fund, managed by Mark Barnett. It was controversially kicked out of the IA UK Equity Income sector two years ago for failing to meet the arbitrary 110 per cent yield target. Barnett remains outspoken about the nature of the IA’s definitions and prefers to ignore it, to focus instead on high-quality stocks with good dividend growth prospects. Investors should therefore not focus too much on headline yield as a total return approach instead relies on the premise that growing capital and a steady or rising dividend payment without the need to take on risk in higher-yielding stocks should eventually trump over the long-term.

Key takeaway: Compressed yields in UK markets are making the job harder for UK equity income managers at a time when they are seeing keen interest as a result of the pension freedoms.