One of the areas worst affected by the pandemic were British dividend-paying stocks, with many of them having to suspend their distributions because of falling earnings. The funds and trusts that invest in these companies had a torrid year, but with dividends being resumed and the vaccination programme well underway, they could be on the verge of a fast recovery.
UK equity income investment trusts were the worst performing sector of the market last year, with an average share price loss of ten percent. It was the same with their open-ended counterparts where the average fund declined by a similar amount.
The negative sentiment towards British companies has been remarkable. Despite total net inflows into open-ended funds of £23.6bn from UK retail investors in the first 11 months of last year, UK equity funds experienced net outflows of just under two billion pounds.
With the vaccine rollout well underway and the worst of the Brexit uncertainty behind us, there is a good chance that British stocks will start to attract more home grown and overseas interest. As companies resume their dividends we could see a major recovery in the performance of the UK equity income sector.
Darius McDermott, MD of FundCalibre, says that the fact that we have avoided a hard Brexit may encourage international investors to start to look at the UK again, but there are still many things to iron out and the bigger tailwind for dividends is the vaccine rollout.
“The vaccine means the opening up of the economy, which in turn means companies can trade again, but don’t expect dividends to return to the level they were for some time. The most distressed sectors will be in survival mode and will prioritise paying down debts before thinking about dividends.”
Companies have adjusted to the pandemic so further dividend cuts are likely to be limited, while some businesses have already begun to reinstate their distributions as confidence returns. The main risk would be if one of the new variants of the virus results in a longer lockdown, or if the economic damage is worse than expected.
Improving dividend outlook
The UK is a high dividend market with the distributions concentrated in relatively few areas and stocks, hence the reason it was hit disproportionately hard by the pandemic. To put it into context, the top 20 dividend paying stocks account for around three-quarters of the total dividends paid in the whole market, so the cuts in the large payers had a huge impact.
Ryan Hughes, head of active portfolios at AJ Bell, says that overall dividends in the UK fell by around 40% last year.
“However, it feels like a corner has been turned and dividends have found a floor, helped by the optimism of the Covid vaccine rollout,” says Hughes. “As a result, dividend growth for 2021 could range from 10% to 15% and although this won’t take the yield on the FTSE 100 index back to its previous level, it will provide welcome relief to those investors who rely on investment income.”
Many businesses have coped pretty well, with numerous companies restarting dividend payments that were suspended at the start of the crisis, while others have confirmed that they will resume shareholder pay-outs later this year. Nevertheless, the virus is still spreading, so winter lockdowns are likely to continue to damage large sections of the global economy in the short term.
Rob Morgan, an investment analyst at Charles Stanley, says that some dividends will be reinstated at lower levels and in the worst affected sectors they could be much lower or not reinstated at all until profitability resumes much later.
“The extent of the dividend recovery is dependent on the path of the virus and how quickly the vaccine rollout takes effect, but we are expecting a good majority of the companies that suspended or cancelled in the first half of 2020 to have brought back their dividends by the middle of this year,” adds Morgan.
Pitfalls for the unwary
When looking at the UK equity income sector it is important to be cautious about the headline yields as these could be historical and might fall again. The key is to look for sustainable dividends and to make sure that the income is diversified, as UK pay-outs are still quite concentrated.
It is also essential to avoid the areas permanently challenged by structural change, which in some cases has been accelerated by the pandemic. While there will be widespread corporate recovery, the true cost of the crisis will only start to reveal itself over the coming months.
Morgan says that many businesses – including property companies and oil and gas operations – will be forced to slash the book value of their assets because they are no longer worth what they paid for them, as well as re-set expectations of future earnings:
“Other businesses will discover that their markets have permanently shrunk and may find it difficult to survive, as online rivals have increasingly made their business models defunct. Active managers will need to ensure they are paying the right price for the earnings and dividends on offer and avoid the ‘value traps’ involving companies that are in a permanent state of decline.”
The big unknown is whether the extensive support from the government will be enough to offset the economic damage from the pandemic. A lot will depend on how quickly the vaccines allow the restrictions to be lifted and whether the economy can bounce back.
The best open-ended funds
When it comes to the individual funds, McDermott recommends LF Gresham House UK Multi Cap Income, which has only been going for three and a half years and has just £77m in assets under management.
“It is multi-cap, so also invests in smaller companies that are growing their dividends, so it gives some of that all-important diversification in the UK market,” notes McDermott. “The yield is still at a reasonable level of 3.4% and the make-up of the portfolio means the fund should do well as the UK economy starts to recover.”
Morgan likes Evenlode Income where the managers focus on ‘cash compounders’, which are businesses that are able to generate high returns on their investments without the need for debt. It is currently yielding three percent.
“The managers believe the ability of selected companies to recycle profits into future growth compounds returns over time and can lead to exceptional results for shareholders,” says Morgan. “They target companies that dominate particular areas with high-quality products where cost for the end consumer isn’t the primary consideration.”
An alternative would be JOHCM UK Equity Income, which includes holdings in economically sensitive stocks, as well as some smaller and medium-sized companies. It has an historic yield of 5.4%.
“The managers take a contrarian approach and tend to gravitate towards out-of-favour areas where higher yields are on offer, which means investing primarily in value stocks. They are highly experienced and well equipped to find the best opportunities in this more risky part of the market,” says Morgan.
Adrian Lowcock, head of personal investing at Willis Owen, likes Threadneedle UK Equity Income, where manager Richard Cowell invests in companies with strong balance sheets and excellent cash flow. It is paying three percent.
“Equities are able to perform well in a moderate inflationary environment. The focus on dividends means the companies are less sensitive to prices and more able to pass any inflationary pressure on through their businesses,” says Lowcock.
Reserves to draw on
Investment trusts have an inbuilt advantage over their open-ended counterparts as they are able to hold back up to 15% of their income each year and add it to their revenue reserves to support their dividends in more challenging market conditions.
Lowcock says that the reserves allow investment trusts to smooth dividends, however, it is just a payment of previous years’ income.
“This helps with cash flow management for the individual, but you can do it yourself so you are not dependent on the income,” says Lowcock. “The preferred option is really an issue of personal choice, as some investors would rather have the cash themselves to choose what to do with it, while others prefer the greater certainty.”
A lot of boards have drawn on the reserves to maintain their dividends, but it is not a one way bet, as although the income falls may have been cushioned on the way down, it probably means investors won’t see the full benefit of the growth in dividends on the way back up.
“Those boards that have used reserves to bolster payments now will almost certainly be looking to replenish those reserves as we go through 2021,” explains Hughes. “However, the smoothing effect is one of the inherent advantages of the trust structure and I’m sure the last 12 months has reminded investors of those benefits given just how lumpy income payments from open-ended funds have been and will be for a little while yet.”
Dividend growth will help investment trusts to rebuild their reserves and will support increased dividends from open-ended funds, but the most important factor in this is stock selection.
Investment trust recommendations
If you are primarily interested in having a growing level of income, Hughes suggests the £250m Troy Income & Growth Trust (LON:TIGT). It is managed by Troy Asset Management, who have a clear focus on higher quality companies that should be able to pay a sustainable income.
“Manager Francis Brook has been very clear that the previously high income of the trust needs to be repositioned into a new group of companies in order to facilitate dividend growth in the post-Covid market,” says Hughes. “As a result, the last dividend was cut back and the trust now yields 2.7% on a forward basis.”
There are enough reserves to cover almost a whole year’s dividend and as the focus is on those companies that can grow their distributions, the payments should increase steadily in the coming years. The largest positions include Diageo, AstraZeneca and Unilever, thereby giving strong overseas earnings to the portfolio and a high quality feel.
The investment trust team at Winterflood have included two trusts from the UK equity income sector in their model portfolio for 2021. They are the £970m Law Debenture (LON:LWDB), which is yielding 3.9% and the £1.15bnMurray income (LON:MUT) that is paying 4.2%.
Winterflood like the fact that Law Debenture earns a significant share of its revenue from its subsidiary Independent Professional Services business, which combined with the almost two years’ of revenue reserves means that the dividend is well-placed to grow. Murray Income is also in a strong position and is expected to build on its 47 consecutive years of dividend increases.
The UK stock market has been badly affected by the pandemic, with many companies having to suspend their dividends to conserve cash. Now that the vaccine rollout is well underway there is a good chance that things will start to get back to normal and businesses resume their pay-outs, which should enable UK equity income trusts and funds to enjoy a strong recovery.
FUND OF THE MONTH
Investors wanting a higher income should look no further than the £1.7bn City of London Trust (LON:CTY), which has been managed by Job Curtis for almost 30 years. It has a current yield of five percent and the board has said that it intends to maintain its long unblemished record of increasing dividends.
“The board has actively used the reserves to maintain the payments and the trust still has dividend cover of more than six months. Large holdings include BAT, Shell and M&G Group, while the ongoing charges figure is just 0.36%, which is great value for an actively managed trust,” says Hughes.
CTY invests in larger companies and benefits from an experienced manager who is very conservative in his nature. He is supported by a board that watches the dividend carefully and is willing to use the revenue reserves to maintain the pay-outs.
“The combination of exceptionally experienced and stable management, a consistent process, low fees and a focus on dividend generation make this a compelling option for investors seeking a core UK equity income holding,” enthuses Lowcock.
City of London has been able to grow its dividend for the past 54 years, which is as good a record of dividend security as you are going to get. There is also the prospect of decent capital gains given the unloved nature of UK equities and the potential for overseas buyers to come back into the market.