The UK stock market is traditionally a haven for income seekers given its well established dividend culture. Certainly, the current yield of the UK market, at around 4%, is significantly higher than the global average (the MSCI World Index currently yields c. 2.4%). However, that headline figure belies some important underlying weaknesses that investors should be mindful of.
According to data from UK Dividend Monitor published by Link Asset Services, dividend payouts from UK companies rose sharply in the first quarter of 2018, by 7.6% to a headline £16.7 billion. This puts UK dividends on track to achieve a full-year payout of £96.3 billion for 2018, making for a rise of 1.8% on 2017 and a new annual record.
However, once we dig deeper into the numbers, the picture begins to look less rosy. The seemingly rapid growth in Q1 was flattered by one-off timing changes from British American Tobacco (LON:BATS), which moved to quarterly payments as part of its acquisition of Reynolds American. Stripping this out, headline dividends would have grown by just 1.2% in Q1; and excluding special dividends – which more than doubled year-on-year – the underlying total was actually down by 0.1%, as a stronger pound took its toll.
But aside from a growth rate that is weaker than headline figures would suggest, a potentially more disturbing issue is the UK market’s reliance on a relatively narrow pool of equities for the majority of its dividend income.
The UK market is too top-heavy
Almost a quarter of the Q1 payout was accounted for by the oil & gas sector, principally Shell (LON:RDSB) and BP (LON:BP.). Although both companies managed to protect their dividend payouts during the commodities slump, the outlook for dividend growth looks weak given the high levels of indebtedness and low levels of dividend cover.
A further one-sixth of UK dividends were distributed by the healthcare sector, chief amongst whom are GlaxoSmithKline (LON:GSK) and AstraZeneca (LON:AZN). Both companies have come under considerable pressure of late, and there has been speculation that their dividend payouts could be under threat. Whether or not that might be the case, what is for certain is that both companies have seen little by the way of dividend growth in recent years.
All in all, the top five dividend payers – Shell, AstraZeneca, BP, Vodafone (LON:VOD) and British American Tobacco – accounted for 47% of total UK dividends in Q1 2018. Moreover, the top 15 dividend payers made up 77% of all UK dividends. Whichever way you look at it, that’s a very top-heavy market.
If you’re invested in UK equity income funds via a pension or an ISA, there’s a good chance that you’re heavily exposed to this cohort of stocks. That might not necessarily be a bad thing – the oil majors might start to grow their dividends again as oil prices rise, and the pharma giants might discover some new blockbuster drugs – but there are many parts of the world that are growing their dividends much quicker than the UK.
Income investors need to diversify
If there’s one take-away here, it’s that income investors need to look further afield to achieve adequate diversification. Globally, dividends payouts rose at a pace of 10.2% during the first quarter of 2018, according to fund manager Janus Henderson. Within that, there were some standout performers: emerging market dividends grew by a third between Q1 2017 and Q1 2018; along with Japan (+16.8%), where a new dividend culture is slowly taking hold; and Europe (+13.7%), which continues to rebound from its recent economic malaise.
Luckily, there are plenty of options for UK investors looking to cast their net a little wider when it comes to their equity income portfolio. When it comes to investing overseas, investment trusts are a good option as they can smooth out the ups and downs of the currency markets to create a steadily rising income stream over time.
Personally, I like Murray International* (LON:MYI), which currently yields around 4.2%, has a strong record of dividend growth and has a greater exposure to emerging markets than many of the other global equity income trusts. The manager, Bruce Stout, is a dour Scot with a very conservative approach to investing.
As well as diversification through geography, there’s also diversification through size. A relative newcomer to the market is the Diverse Income Trust (LON:DIVI), managed by renowned small-cap fund manager Gervais Williams of Miton. The trust invests across a range of market capitalisations, with the majority (55.4%) of the fund invested in smaller companies. There are many smaller companies with excellent records of dividend growth, and this trust is an easy way to gain exposure to that income stream.
* James owns shares in Murray International.