Cover story: The future for equity income looks bright

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While the prolonged backdrop of ultra-low interest rates has significantly bolstered the popularity of UK Equity Income funds, yield-hungry investors are now hoping the new political landscape will provide the asset class with a fresh shot in the arm.

As the General Election results rolled in on 8 May, the City’s reaction became abundantly clear. By the end of the day’s session, by which time the success of the Tories was sealed, albeit by a slim majority, the FTSE 100 had closed more than two per cent ahead, while the FTSE 250 had risen by three per cent.

Notably industries known for their dividend payments, including banks and utility firms, partook in the gains. The Labour party’s threats to tax banker bonuses and implement price caps on energy firms had significantly faded and the market had welcomed the more business – and therefore investor – friendly Conservatives back into full power.

As a result advisers and fund managers believe the future for dividend paying firms, and with them equity income funds, could now be that bit brighter. 

Informed Choice chartered financial planner Martin Bamford says: “We see a slightly rosier future for the UK equity income sector following the recent election results, with the British business community likely to prosper under a majority Conservative government. With greater business confidence we expect to see dividends start to pick up now, against the backdrop of a hopefully more positive economy, both domestically and globally.”

JO Hambro UK Equity Income co-manager James Lowen has also welcomed the “certainty” of the election result: “At the margins, it should be positive for the banking sector, but what is more important is that the entrenched economic recovery enjoyed in the UK now faces less chance of being derailed.”

Questions do remain over the strength of the UK economy given that GDP growth in the first three months of 2015 slipped to just 0.3 per cent, according to official numbers – half of what it delivered in the final quarter of 2015. More positively however figures released in May highlighted that employment reached 73.5 per cent during the quarter, the highest level since records began in 1971, while unemployment continued to fall and wages were rising ahead of inflation.

However inflation at the last count was running at -0.1 per cent, a far cry from the Bank of England’s 2 per cent target. In the Bank’s latest inflation report, governor Mark Carney asserted that the cost of living is likely to pick up notably coming into the end of 2015. But the Bank also cut its 2015 growth forecast from 2.9 per cent to 2.5 per cent, and for 2016 from 2.9 per cent to 2.6 per cent. Carney added that he anticipates interest rates will rise from their record-low 0.5 per cent sometime in the second quarter of next year. 

For his part Neil Woodford, manager of the CF Woodford UK Equity Income fund, which marks its one-year anniversary in June, believes the UK economic outlook looks somewhat subdued over the next five years, regardless of the recent election result. 

“A less conclusive result would clearly have been worse for the economy because of the associated political uncertainty, but our assessment of the UK economy suggests we should expect modest growth at best over the next few years,” he says.

Nonetheless recent years have marked a significant period for equity income strategies. With volatility and uncertainty plaguing bond markets and savers getting negligible returns from cash deposits, the sector’s appeal has risen, with yield hungry investors collectively pumping billions into the asset class.

UK Equity Income, with net retail sales of £6.3bn, was the best-selling sector last year, topping the charts for eight of the 12 months, according to numbers from trade body the Investment Association. Its appeal has held up into 2015 and in the IA’s last count housed £60.2bn in assets under management.

Of course, it enjoyed a major boost on the back of the UK’s biggest ever fund launch with the aforementioned CF Woodford UK Equity Income portfolio. Since inception it has witnessed its assets grow to a hefty £5.3bn as investors have flooded in, hoping the star manager will continue the run of strong performance he enjoyed during his time at Invesco Perpetual.

But returns from IA’s UK Equity Income sector overall have been reliable with the average fund delivering a total return of 74 per cent over the past five years, surpassing the FTSE All-Share’s 65 per cent achievement for the period.

Dividend outlook

With a yield of 3.3 per cent on the UK stockmarket and fixed income markets showing ever-greater volatility, many advisers believe shares still provide some of the best opportunities for generating an attractive level of income.

The bias of the FTSE 100 towards energy and mining has raised concerns over the prospects of dividend growth following the slump in commodity prices towards the back end of 2014.  However, Whitechurch Securities managing director Gavin Haynes believes the recent rally in the oil price has provided some relief. He says: “I believe that the UK market will see dividends grow above the current low level of inflation and this will support the popularity of UK equity income sector.”

JPMorgan Claverhouse investment trust co-manager William Meadon asserts that given that many sovereign bonds are now offering nothing in yield terms, coupled with the fact that many company balance sheets are resplendent with cash, the market is offering investors a real “sweet spot”.

“The FTSE 100 is now on a prospective yield of 4 per cent, versus a historic average of about 3.5 per cent and dividend growth is expected to be about 6 to 7 per cent, and I believe that could surprise on the upside,” Meadon adds.

The latest and widely observed Capita Dividend Monitor expects the UK will enjoy the strongest dividend growth this year since 2012. Specifically it anticipates that headline payouts will hit £86.5bn, with underlying dividends, which strip out special payments, up 6.4 per cent. 

Notably however during the first three months of the year headline dividends came in at £14.75bn, a sharp 52 per cent drop on the same period in 2014. But at the underlying level, the total reached £14.49bn, down just 0.3 per cent year-on-year. 

This still masks a number of factors. Firstly, Vodafone paid its bumper world record £15.9bn special dividend in the first quarter of 2014, distorting annual comparisons at a headline level. Additionally, Barclays delayed the payment of its final dividend by five days, shifting £630m of first quarter dividends into the second.

Justin Cooper, chief executive of Shareholder solutions, part of Capita Asset Services, admits that while the first quarter pales in comparison to a year ago at a headline level, under the surface, “things are clearly picking up pace”.

He says: “At one end of the FTSE, mid cap domestically orientated companies, most sensitive to the UK’s economic growth, are able to increase the returns they are offering shareholders at a dramatic rate. At the other, dollar strength is helping buoy payouts from the UK’s most internationally exposed firms – a stark contrast to last year. And equities have extended their lead over other asset classes in their ability to provide such a good income.” 

Opportunities

One sector that has caught fund manager attention once again is banking and financials in general. The return of Lloyds to the dividend register this year was widely viewed as a pivotal moment, in that it brought the industry that bit closer to achieving a full bill of health.

For Schroder UK Alpha Income manager Matt Hudson financials are a key sector right now. He says: “Bank reports have been more robust and hopefully there will be a better dividend flow from the sector than there has been over the past four to five years.”

JO Hambro’s Lowen says he and co-manager Clive Beagles have been moving capital out of insurance names and into banks. “On a pan-European basis banks have only been cheaper on four other occasions over the last 35 years – during the real estate crisis in the early 1990s, the TMT bubble, the Lehmans crisis and the European sovereign bond crisis,” he says. 

But while the FTSE All-Share has rocketed by 163 per cent since the nadir of the crisis in March 2009, yields have naturally come down.

Evenlode Income manager Hugh Yarrow points out that given the way valuations have risen the landscape is not as attractive today as it once was. The manager of the £293m portfolio says: “We can still buy sensible companies, such as Unilever that offer a three to four per cent yield. That is not a bad starting point, but it is not as good has it has been.” 

For Yarrow consumer branded goods and media stock, including Pearson, are primary plays in the current backdrop. He says: “Media groups tend to have low capital requirements. They pay a healthy dividend while investing in the business for the long term.”

JPMorgan Claverhouse’s Meadon also likes the consumer sector right now, including the likes of Next and Dixons Carphone. He says: “With the oil price down, that is money going into peoples’ pockets. The typical American is now on average about $1,000 a year better off as a result.”

Another key pick for the manager of the £453.8m investment trust is high street baker Greggs. He says: “Cash generation is strong and likely to improve further as management works through the estate revamp. The company recently announced the first of what we expect to be a series of special dividends.”

Carl Stick, manager of the £1bn plus Rathbone Income fund, began looking at the financial sector just over a year ago and increased his allocation “in a broad sense”, partly to provide some insurance against a tightening of monetary policy.

He says: “We are in an environment where we may see interest rates rise. A lot of financial businesses tend to benefit when rates increase. When they do rise we may see some share price weakness so we need to ensure we are paying the right price today.”

But Stick too, has been looking to consumers, citing Frankie & Benny’s owner The Restaurant Group, retailer Next and kitchen firm Howdens Joinery as some of his main plays.

Risks

But while the economic backdrop continues to gradually improve and the new political stability has been widely embraced, plenty of obstacles still remain, especially in the supermarket sector, where payouts are vulnerable as the UK’s big players including Sainsburys, Morrisons and especially Tesco, suffer stiffer competition on the back of the rise of the so-called hard-discounters such as Lidl.

One major potential speed bump for the near future is Europe, should the British people get, as pledged, a referendum on European Union membership. Bamford says: “It is too early to judge which way this might go, but I suspect it would have negative consequences for blue-chip listed companies in this country, which derive a lot of revenue from European customers. Anything which makes it harder for Britain to do business in Europe is likely to result in lower dividends. 

Meadon is confident however that the ‘stay-in campaign’ will pull out all the stops and put forward a compelling case. He adds too that worries over the sterling’s strength hitting UK listed firms, which chiefly gain their revenues from overseas, have been over done, and that the more robust pound is just an act of “mean reversion” following a period of weakness.

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Evenlode’s Yarrow however asserts that the biggest risk to dividends is under-investment and companies trying to maintain their payouts. He says: “The oil majors, such as BP and Shell, have decided to protect their dividend but have slashed their capital investment, on the back of the fall in the oil price, which could impact future growth. I want the firms I invest in to be investing for their own future growth.”

What are advisers recommending?

Given the level of inflows CF Woodford Equity Income has seen, it is fair to say the portfolio is a fixture on many ‘buy’ lists.

But the sector has a decent slug of managers on advisers’ radars. The preferred choice in this sector for Informed Choice’s Bamford is Stick’s Rathbone Income vehicle, which has achieved an 85 per cent return over the past five years to 14 May.

Bamford says; “Carl has run this fund for over 15 years and it is very much a fund for long-term UK equity income investors. Stick has a consistently applied value strategy, investing in stocks with healthy yields and a good outlook for growing their dividends in the future. It is a good fund for capital preservation, although can fall behind the sector at times, as it tends to avoid highly cyclical stocks.”

He also rates James Lowen and Clive Beagles’s JO Hambro UK Equity Income, which has delivered a total return of 93 per cent over the past five years. “The fund is however currently soft closed to new investors, so expect to pay a premium to invest,” adds Bamford.

Haynes says when it comes to portfolio selection, he is typically looking for fund managers who will go against the herd and seek value in out of favour areas of the market. “Schroder Income Maximiser is a good example, with unfashionable areas such as banks and supermarkets having prominent positions in the portfolio.” However over five years, it is trailing the sector mean of 74 per cent, with a 60 per cent return.

For his part Axa Wealth head of investing Adrian Lowcock tips the £3.4bn Threadneedle UK Equity Income, up by 90 per cent over five years. He says: “Managers Leigh Harrison and Richard Caldwell use a combination of fundamental company analysis with their understanding of the wider economic picture to build a portfolio of high-quality stocks. Their disciplined approach to building a high-conviction portfolio with strong sector bets has resulted in consistent outperformance.”

Lowcock also rates the £364.2m Chelverton UK Equity Income, which is arguably less well known than some of its peers but has delivered a stellar 125 per cent total return over five years. “The managers David Taylor and David Horner target a yield of 4 per cent and focus on business and balance sheet strength. Whilst the fund is likely to be more volatile than large cap equity income funds it should be less volatile than smaller companies growth funds.”

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Value in investment trusts

On the back of the ever-growing dash for yield a plethora of UK equity income investment trusts have seen their discounts narrow, and even move into premium territory over recent years.

But following a modest re-rating there is now some value on offer with discounts having widened back out once again.

Anecdotally, some have suggested the arrival of Neil Woodford’s Woodford Patient Capital Trust, the UK’s biggest investment trust launch after raising a massive £800m, has drawn some money out of the sector and therefore pushed discounts out. 

But given the open-ended space during the busy end of tax-year period witnessed sales slump to £585m between 1 March to 5 April, compared to £822m a year earlier, it is very likely that some pre-election tension crept in as investment trust investors turned cautious too.

However, advisers believe the better deals on offer across the investment trust arena are pointing to a potential buying opportunity for income seekers given the strong track record from the sector.

In fact, data from the Association of Investment Companies shows that more than a fifth of its members that have been in existence for more than a decade have upped their dividends for at least 10 years in a row. Within this total, 50 per cent of the UK Equity Income sector has raised its payouts for at least 10 consecutive years.

Schroder Income Growth, presently on a discount of 5.1 per cent, for example, has upped its shareholder payouts for the past 19 years. Invesco Income Growth, on a discount of 8.2 per cent, has achieved 17 consecutive years of dividend increases.

Within the sector, Whitechurch’s Haynes favours the Alistair Mundy run Temple Bar, which is yielding 3.2 per cent. Presently on 3.4 per cent discount, the £966.7m trust has raised its dividend for 31 consecutive years. “Due to popularity, performance and the current demand for income, you need to keep a close eye on the pricing as it can go to a large premium at times,” says Haynes. 

Killik & Co head of research Mick Gilligan highlights the £217.1m Standard Life Equity Income fund. Launched in 1991, and currently managed by Thomas Moore, the trust has raised its payouts for the past 14 years and is trading at a 7.4 discount and yielding 3.3 per cent.