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From the experts - UK Equity income

Mark Barnett

Investing for dividend growth

Mark Barnett, head of UK equities at Invesco Perpetual, explains why the current level of dividend yield is unlikely to be the main driver of the investment decisions he makes

As I am sure you will have noticed, the dividend yield pattern in the UK equity market has become somewhat bipolar. There are some high dividend yields available from certain major sectors although these come with question marks over growth and sustainability.

Based on consensus forecasts from Bloomberg as at 30 September 2015, the oil & gas producers sector is expected to generate 17% of the UK equity market’s dividends in the calendar year for 2015. On the same basis, the banks sector is expected to generate 13%, pharmaceuticals 9%, mining 7% and telecommunications 5.6%. This means a total of 51.6% of the market’s income is expected to be generated by companies comprising 38.8% of its market capitalisation as at 30 September 2015.

Figure 1 below shows the expected income share of certain key sectors as represented by the size of the bubbles for 2015. This is compared with the historic (last 12 months) dividend yield of the sector and the expected dividend growth rate in the next full calendar year – 2016.

Figure 1: Historic dividend yield and expected dividend growth rates - UK equity market sectors

Source: HSBC forecasts and Bloomberg, as at 30 September 2015. Historic dividend yield covers 12 months to 30 September 2015. Area of bubble represents the share of UK equity market dividends.

 

You can clearly see the effect of dividend cuts in the mining sector coming through as well as the static picture for dividends in oil & gas and pharmaceuticals. Banks are expected to show good growth in 2016 but this is mainly based on an assumed step change in Lloyds’ dividend distribution policy.

The higher-yielding sectors are populated by very large companies. We can see this size effect more generally by comparing the relative dividend yield of the largest stocks compared with the FTSE 100 index average. Figure 2  below shows the trend since 1990 – the ratio reached a record 160% at the end of July.

Figure 2: UK super mega caps relative dividend yield is at an historic high
Source: Exane BNP Paribas as at 30 September 2015

 

Looking at it from another angle, the top 10 yielding stocks in the FTSE 100 (which comprise 25.4% of the index’s value) have expected dividend yields of between 6.1% and 8.3% for 2015 (see Figure 3 below).

Figure 3: Top 10 FTSE 100 index - 2015 forecast dividend yields
Company Dividend yield (%)
Anglo American 8.3
BHP Billiton 8.1
Royal Dutch Shell (A and B) 8.0
BP 7.9
Aberdeen Asset Management  6.9
HSBC 6.9
Rio Tinto 6.8
Admiral Group 6.4
GlaxoSmithKline 6.3
SSE 6.1
Source: Bloomberg as at 30 September 2015

 

The level of dividend yields on these large cap stocks is a function of their industry conditions, their distribution history and, in some cases, investors’ doubts over the sustainability of the dividends. The dividend pay-out ratios of the earnings of the oil, mining and pharmaceutical sectors on 2015 forecasts are all over 80% – in other words, earnings need to start rising for dividend growth to resume.

Indeed, we are currently witnessing a period of dividend cuts from some high-profile companies – among others, Tesco, Standard Chartered, Glencore, Wm Morrison, Sainsbury, RSA and Centrica have all reduced or eliminated their dividends in 2014/15. And there is a risk of more to come.

Several of these high dividend yielding stocks and sectors have been excluded from all the portfolios I manage for some time, although I hold large weightings in pharmaceuticals and also hold some midcap high-yielding companies in the general insurance sector. I do like telecoms, but do not hold the highest-yielding stock, Vodafone (see Figure 4).

Figure 4: Invesco Perpetual High Income Fund – significant sector weightings
Sector Portfolio (%) FTSE All-Share index (%)
Pharmaceuticals 15.3 7.7
Banks 0.0 10.7
Oil & Gas Producers 2.9 10.0
Mining 0.0 3.9
Tobacco 15.0 5.1
Fixed Line Telecommunications 4.6 2.0
Mobile Telecommunications 0.0 3.1
Source: Invesco Perpetual as at 30 September 2015

 

I have been prepared to forego higher current dividend yields for what I perceive to be more secure future dividend growth and this is reflected in the changes I have made to the Invesco Perpetual Income and High Income Funds since taking responsibility for them in March 2014.

In order to achieve more diversification and a broader opportunity set, I have reduced the concentration in the top 10 holdings, selling significant amounts of AstraZeneca, SSE, BAE Systems and a few others. I have also sold out of GlaxoSmithKline completely and have accepted a takeover offer for the funds’ holdings in Amlin (see Figure 5). All of these companies currently offer dividend yields above that of the stockmarket. This has enabled me to increase commitment to other major holdings as well as introduce new ideas.

Figure 5: Invesco Perpetual High Income stock weightings 28/02/14 v 30/09/15
Company Weight as at 28 Feb 14 (%) Weight as at 30 Sep 15 (%)
AstraZeneca 9.8 4.3
GlaxoSmithKline 9.3 Sold
Roche 5.5 3.1
BAE Systems 5.2 3.5
British American Tobacco 5.0 4.6
Imperial Tobacco 4.9 4.5
Capita 4.9 2.7
BT Group 4.5 4.0
Reckitt Benckiser 4.5 1.3
Rolls-Royce 4.1 0.9
Source: Invesco Perpetual as at 30 September 2015

 

I am also interested in companies that are genuinely innovative, believing this is one way to counteract the pressure the corporate sector is feeling on top-line growth. This includes some early-stage bioscience companies that are currently low or zero dividend-paying, but could deliver the best dividend growth of tomorrow.

Having reshaped the funds I manage over the past 18 months, I hope investors can see portfolios that are more broadly-based than previously, sensibly diversified and capable of accessing excess returns across the market cap spectrum over the longer term.

The emergence of high-yielding mega-cap stocks is partly the corollary of their recent underperformance and the doubts over the sustainability of those dividends. By the same token, the historic yield on, for example, the Invesco Perpetual High Income Fund (3.16% as at 30 September 2015) is partly a function of its strong capital performance.

As to the future, I continue to meet the management of all major UK companies whether they are held in the portfolios I manage or not. I am interested in hearing how they are approaching the extraordinary challenges that arise from a low nominal GDP growth environment.

I have no doubt the best brains will find a way through the obstacles and adapt their business models to the new realities, whether they be lower for longer commodity prices or the challenge of capital management and dividend policy in a more highly regulated and politicised banking environment. Where I find a situation I believe is compelling in this space, I am happy to invest with conviction, as I have done already with BP. However, the level of current dividend yield is unlikely to be the main driver of any decision I make.

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