Equity income investing – targeting shares with decent dividends to provide income or to recycle into growth – has been through a bad patch. The onset of the pandemic in 2020 saw a significant number of companies cut their dividends or cancel them altogether, which meant investors looking for income from shares were left short.
The picture is now changing. Lots of companies cut their pay outs last year out of prudence and because the future was so uncertain. They are now in a good position to reinstate and boost dividends as the worst of the pandemic – and it shocking effects – appear to be behind us. As companies grow in confidence it means the income from UK investments should grow from what is currently a decent starting point and provide a significant and growing income to investors.
Yield – an income yardstick
An idea of how much income an investment produces is given by its ‘yield’. This is generally the amount of income paid over the past year divided by its price and expressed a percentage. For example, if a share is valued at £1 and has paid out 5p per share in dividends from its profits over the past year the yield is 5%. Yields are variable because they are calculated based on the price – which moves – and the fact that the income paid can change, which is especially the case with shares as opposed to bonds whose income is generally fixed.
Historically, the UK stock market has been a high yielding market, partly reflecting the predominance of ‘old economy’ companies in areas such as energy, mining, financials and tobacco. This is in contrast to the US market, for instance, which is dominated by technology stocks, many of which pay little in the way of dividends to investors. Amazon, for instance, famously pays no dividend because it recycles all its profits into future growth – a strategy of course that has led to excellent returns and could continue to do so.
UK companies are mainly in more mature industries where there is less growth available, which combined with the more embedded dividend ‘culture’ leads companies to return more cash to shareholders. It’s reasonable to expect a yield in the region of 3-4% from a collection of UK ‘blue chip’ shares, and through investing wisely this income steam could grow over time. As income grows, share prices often follow as companies become more attractive to investors.
Chris Ainscough, manager of the Charles Stanley Monthly High Income Fund, points out that UK companies tend to fall into two main groups following the fallout from Covid, which disrupted the payment of dividends: “Those with solid fundamentals, sustainable business models and appropriate distribution levels have relatively quickly turned the taps back on as uncertainty receded, whereas those that were paying out more than they probably should have been have used the past year as an opportunity to rebase their payments to levels they think they can sustain.”
Going forward, UK dividends ought to therefore be on a more sustainable footing and there is much less risk of substantial cuts than there was pre-Covid. The biggest exceptions to the improving dividend trend have been the major energy stocks and some consumer businesses that are still facing Covid issues such as the ‘pingdemic’ restricting the supply of workers.
There is also a reasonable starting yield on offer compared with overseas markets as the chart below shows. This partly reflects the large number of UK companies in mature sectors where sizable dividends are expected to be provided, as well as the significant valuation discount to which the UK market stands compared with overseas developed markets – as much as 40% according to Polar Capital, a 30-year low.
Chart: % yield available from major world markets
With Brexit behind us and the population mostly vaccinated, the UK does now enjoy something of an advantage over other parts of the world. Perhaps more importantly it is no longer seen by the rest of the world as a ‘pariah’ in investment terms. Interest from overseas investors is picking up, evidenced by a number of UK firms being approached by overseas buyers sensing bargains versus comparable companies in the US or Europe.
A recent improvement in the UK’s relative performance may also be a result of the apparent economic upsurge from successful vaccines and re-openings, both domestically and globally, and the more ‘reflationary’ environment that this has brought which favours economically sensitive (or ‘cyclical’) areas such as commodities and banks. Even so, the mini resurgence in interest has not left UK large caps looking expensive relative to their history or their peers, which could mean there is more to run in the trend of UK outperformance.
As always there are risks. The cyclicality of the UK stock market has meant it has a brief return to popularity, but Covid-related setbacks or surprise interest rate rises from central banks could serve to dampen economic revival and hamper the UK stock market. Even if it is slow progress from here in terms of capital returns, though, investors should at least enjoy a decent income, which can also be reinvested to ‘compound’ returns over time instead of being taken.
UK Income options
Rather than focus on a small number of high yielding shares, investors could consider a fund that spreads their money across a variety – so to reduce reliance on specific companies and to harness the skills of a professional fund manager.
TB Evenlode Income – modest but resilient income
One high-quality UK income fund option is TB Evenlode Income Fund managed by Hugh Yarrow and Ben Peters whose straightforward strategy aims to provide investors with a decent, growing income with some capital growth on top. They focus on what they call ‘cash compounders’, businesses able to generate high returns on their investments without the need for debt. The right businesses of this type can consistently recycle profits into future growth and roll up exceptional returns over time – leading to decent results for shareholders.
In particular, the managers target companies that dominate particular areas with high-quality products where cost for the end consumer isn’t the primary consideration. Consumer goods, healthcare and pharmaceuticals, media firms with hard-to-replicate ‘intellectual property’ and specialist engineering companies are among the areas they often find opportunities in.
This type of good-quality, global leading company can have expensive shares, but the managers believe it is often worth paying a higher price for stable companies whose increasing profits can be forecasted relatively easily. Consequently, the fund has a fairly low starting yield of 2.3% (variable, not guaranteed) and as such sits in the Investment Association UK All Companies sector rather than the UK Equity Income sector. As well as investing in UK firms there can be some exposure to selected European or US stocks too.
The fund’s process frequently results in a number of key UK sectors being excluded such as mining, banks and utilities, which don’t have the ingredients the managers are looking for: high and growing cash flows and low levels of debt and business risk. The fund’s performance could therefore deviate from the wider market, and in particular from funds that are focused on more economically sensitive areas.
JO Hambro UK Equity Income – a more economically sensitive income fund
For those wishing to focus more on the cheaper areas of the market and potentially harness recovering dividends, equity income funds with exposure to economically sensitive stocks and domestic earners could provide greater return potential in a positive economic scenario.
One option is JOHCM UK Equity Income. Established income investors Clive Beagles and James Lowen have a strict dividend yield ‘discipline’, which leads to an emphasis on higher-yielding stocks and promotes a naturally ‘contrarian’ style. We believe they have a high quality, repeatable process, which is always forcing them to look where value exists, and we admire their willingness to own both large and small companies, as long as they meet their investment criteria.
Amid the Covid crisis, income pay outs from the fund fell by 40% in 2020 compared with 2019, but they could rebound strongly as economic recovery comes through. More economically sensitive areas such as energy and mining, which are heavy sector positions in the fund, have already seen share prices rise significantly as cheaper areas of the market awoke from autumn last year – so while income should be healthy, an investment could fluctuate in value quite a bit with changing expectations of economic growth and the lingering impact of Covid. The yield is presently stated as 5.6%, variable and not guaranteed.
Charles Stanley Monthly High Income
This is a more cautious ‘multi asset’ option for those that would like to blend the income characteristics of bonds with UK and overseas shares. Charles Stanley Monthly High Income Fund is monitored and rebalanced by Charles Stanley experts and has a yield of around 4% (variable, not guaranteed), so it could represent a more stable income-producing fund in a portfolio.
The aim of the fund is to produce a high and sustainable income while seeking to preserve capital. It blends a variety of our best income ideas to provide a resilient and varied portfolio. The fund invests at least 60% in government and corporate bonds and seeks opportunities in UK and overseas equities as well as alternative areas such as preference shares or infrastructure.
With monthly pay outs this fund could appeal to a wide variety of investors looking to achieve a good level of regular income as well as the potential for some growth in income and capital over time. The fund is already popular with many customers, particularly those with pension drawdown who value the combination of a robust and regular income combined with relatively low volatility of capital.
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