As earnings season gets into full swing, the FTSE 100’s heavyweights have been on show. Income-hungry investors will have paid close attention to recent results from Royal Dutch Shell and pharmaceutical companies GlaxoSmithKline and AstraZeneca, as well as updates from Diageo, British American Tobacco, Vodafone, BT and Reckitt Benckiser.
Shell and GSK offer yields of more than 5 per cent. Along with the other names above, this group of companies account for the lion’s share of UK dividends. However, it is rarely a good idea for investors simply to anchor themselves to the headline yield. It only tells you half the story.
Shell, GSK and AstraZeneca have all maintained their dividends, even though, at times, those dividends weren’t covered, and the underlying business dynamics pointed towards a dividend cut.
Shell, one of the world’s biggest income payers, maintained its dividend throughout the oil price fall via a scrip dividend programme, conserving cash by offering investors the choice of shares in lieu of cash dividends. For a while, only two-thirds of its dividend was paid in cash, the rest was settled by issuing shares. Last week’s share buyback announcement is, in large part, to offset the dilution caused by issuing more shares during the hard times.
AstraZeneca has sold off bits of its intellectual property, generating “externalisation revenues” (in accountant speak) to keep its cash flow ticking over as pressures mount over patent expirations and competition.
GSK hasn’t covered its dividend by the cash it generates for a number of years (although it has by earnings). That explains why it is holding on to its consumer business — the cash generated can support the pharmaceutical business which is suffering from a decline in profitable drugs as cheaper rivals emerge.
If you’re an income investor, dividend cover matters — and even more so when the economic sands shift. Investors need to question what will happen in the event of a downturn, commodity price fall or drug patents expiring.
It might be that companies have the will and means to bridge such an income hiatus. But it’s worth doing your homework, given the highly concentrated nature of the UK’s dividend payers. The top five dividend payers — Shell, HSBC, BP, British American Tobacco and GSK — account for almost half of all FTSE 100 income. If one of these powerhouses suffers a cut, the impact will be significant.
Those holding UK shares and equity income funds need to be mindful of diversification. A high overlap of holdings — known as “dividend clustering” — could leave you more exposed than you realise.
Then there’s the challenge of Brexit and the currency volatility that comes with it. About 70 per cent of FTSE 100 company earnings are non-sterling based. Of course, this can be a double-edged sword — as sterling weakens, the alchemy of exchange rate gains has tended to boost UK dividends in recent years.
A global equity income fund can mitigate many of these challenges. There’s the obvious benefit of having more stocks to choose from, giving the fund manager more opportunity to add value.
These funds aren’t as exposed to the company and sector skews of one region — for example, the UK is dominated by financials and commodities (circa 45 per cent of the FTSE) but relatively tech-poor. Global equity income managers often hold “old tech” — companies such as Cisco and Microsoft — alongside more “cyclical tech” companies like Taiwan Semiconductor, offering steady dividends at reasonable valuations.
With a global fund, currency volatility is mitigated by the simple fact that the fund holds exposure to a basket of different currencies, which will rise and fall against each other throughout the economic cycle. If you’re holding two or more global equity income funds within your portfolio, there is likely to be far less overlap in stock names than with UK equity income funds.
Other than going global, another way of building diversification into your income portfolio is by moving lower down the cap size scale. Many professional investors argue UK small and mid-caps offer better dividend growth prospects than their larger peers.
Carl Stick of the Rathbone Income Fund holds a number of UK businesses he believes are well positioned to benefit from the rejuvenation of the US domestic economy. IT company Sage helps small and medium-sized businesses use technology to deal with essential functions like account management, HR and payroll putting it in a strong position to benefit from US start-up activity. Likewise, UK insurer Hiscox has a growing business in the US targeting small enterprises, while Daily Mail and General Trust makes 38 per cent of its profit from North America through a mix of consumer, education, insurance and media businesses.
National Grid and WEC Energy both generate huge revenues from the US with National Grid owning the landmark Niagara Falls hydroelectric power plant.
Meanwhile, Neil Woodford, the fund manager, is staying laser-focused on out-of-favour UK domestic stocks. The Woodford Income Focus Fund holds a number of housebuilders boasting decent dividends such as Barratt Developments, Taylor Wimpey, Crest Nicholson and Bovis. The fund’s biggest holding is Imperial Brands, yielding around 7 per cent. Another interesting holding is the property company New River Reit, yielding 8 per cent.
Mr Woodford tells me he believes deteriorating global liquidity conditions will come to haunt markets in coming months. “The elastic between the valuation of the popular stocks such as Facebook and Apple in the US — or in the UK, anything which offers investors exposure to Asian growth and that of the unpopular stocks such as the healthcare sector and domestically-focused companies — is reaching breaking point,” he says.
Special dividends are another way to diversify your income pool — although these can be tricky to predict. Sky didn’t pay anything to its investors in 2017, but as its acquisition story unfolded, cash built up on its balance sheet — resulting in a special dividend in the first quarter of this year. The housebuilders and airlines can also be rich pickings for “specials”, although weak sterling has provided unwelcome turbulence.
Paying a special dividend could imply a company’s reluctance to splash the cash given a lack of growth opportunities, or a bet that strong cash generation will continue. Either way, it’s a guessing game. Many investors will prefer the steady income of the dividend staples — even if this comes with a long list of caveats.
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