Predictable income: is it possible?

HUB NEWS PANEL DISCUSSION 2021


Panel discussion, hosted by Cherry Reynard, with:
Simon Young – Portfolio Manager, UK Equities, AXA Investment Managers
Jan Oliver – Partner, Income Strategies, Baillie Gifford
Jason Borbora-Sheen – Portfolio Manager, Diversified Income Fund, Ninety One


Predictable income: is it possible?

2020 threw income investors a curve ball. Companies faced a challenge just to stay afloat and paying dividends was an inevitable casualty. That said, many equity income managers managed to swerve the worst of the dividend cuts and sustain their payouts to investors. What is their secret for generating reliable income and are they optimistic for the year ahead?

The Link Group’s UK Dividend Monitor showed UK dividends for 2020 falling by 44%. This was in spite of a resumption in payouts in the fourth quarter. Banks, forced to suspend payouts by the regulator, were the weakest spot, accounting for two-fifths of the cuts, but the previous dividend stalwart, the oil sector, was also hard hit.

Simon Young, manager of the AXA Framlington UK Equity Income fund, says his fund took less than half the hit of the wider market. His four factor approach, aimed at uncovering companies with key competitive advantages was crucial in finding those companies able to survive the unexpected. He says: “When you look at most forecasters, they tend to miss recessions and the pandemic was a prime example.

“Our four factor approach looks for the lowest cost producers, where they can survive because they can price their product at a lower cost than competitors and still make money. We look for businesses with high levels of repeat income, such as subscriptions. Accounting software group Sage is a good example. We look for businesses with strong sales networks, the ability to expand and sell their product whenever and wherever. Finally, we look for businesses with high levels of intellectual property, such as a brand or patent. These factors give businesses resilience to keep paying dividends through the tough times."

Warning signs

On the flip side of this are the red flags. High leverage, increased competition and adverse regulation are all problematic. The march of technology is a problem in specific sectors, where companies are finding previously effective business models obsolete.

Jan Oliver, a partner in the actual income team, at Baillie Gifford, says the group’s approach is to find companies that are growing their business and therefore can grow their dividend organically. She says: “We invest in companies that are themselves investing in their own long-term future, rather than being too driven by the next quarter’s cash flow. The companies paying out dividends from yesterday’s businesses are of no interest to us at all.

"We think the paradigm of income investors – just focusing on troubled companies that are paying a high yield is being thrown into history. We want good strong, growing companies with bright prospects and resilient dividends. We are after long-term income not short-term yield. It’s a mistake to try and prop up yields at the expense of long-term income. We think that the biggest risk comes from short-term thinking.”

Key risks

Jason Borbora-Sheen, fund manager on the Ninety-One Diversified Income and Cautious Managed funds, believes that now is a good moment to re-examine the equity income sector: “Equity income strategies underperformed and saw falling yields last year. This has switched in the last few months , when better economic prospects have gone hand in hand with better earnings prospects.”

However, there are risks – inflation, for example. There is a danger that higher inflation makes dividend income less valuable. As it stands, Borbora-Sheen believes inflation worries may have been overdone. He says: “It’s quite possible that we will reach a peak in inflation expectations in May of this year and real inflation doesn’t come through as expected.” He says inflation may reassert itself later in the year, primarily in the US rather than Europe and the UK.

For him, the biggest risk is an earlier, more aggressive move to tightening monetary policy from the Federal Reserve: “That would be a very destabilising force and one that the market is currently paying a lot of attention to".

Inflation

Young remains optimistic on the prospects for UK Equity income: “We’ve had a successful vaccine rollout. Management teams have been cautious in their guidance and I believe we’ll see trading at the better end of the spectrum. Dividend growth could be 5-10% this year. UK also in a good space on its starting valuations.” Jan agrees, saying that 2020 delivered an unprecedented stress-test for companies.

Borbora-Sheen believes that equity income compares well to other income options, such as gilts or closed-ended listed infrastructure. However, investors shouldn’t lose sight of capital growth: “Income is a building block for total returns. All investors need to focus on total return, rather than seeing yield as distinct from capital.”