No drought in dividends

Posted by Liz Rees in Latest insights category on 13 Dec 18

When markets go through a period of heightened volatility, as we are seeing at present, one source of comfort is receiving a reliable stream of income from your investments. While the protracted Brexit process may be unsettling, the sell-off has certainly not been confined to the UK. Markets around the globe have reacted to trade war threats and rising interest rates.

Nevertheless, despite these ongoing concerns the corporate sector overall remains in robust health. Many conservatively run businesses have built up substantial cash reserves which they are paying out to shareholders, sometimes as special dividends.

The facts

The latest Janus Henderson Global Dividend Index, published in November, revealed underlying (adjusted for currency and special dividends) annual growth in Q3 of 9.2%. This exceeded expectations. At a regional level, underlying growth was 7.6% in the US, 9.1% in Europe, 6.8% in Asia, 9.2% in Japan, 11.1% in the UK and 15.7% in Emerging Markets. This reflects a strong world economy, boosting corporate profitability around the globe, with Janus Henderson forecasting global dividend growth of 8.1% for 2018. 

UK stands out, but careful selection needed

Across the globe, there was strong growth in pay-outs from banks and resources companies. The UK has a large exposure to both these sectors, benefitting in particular from significant dividend hikes from BP and Barclays. BP held its dividend when the oil price was depressed but is now starting to share the rewards of subsequent recovery. That said, do bear in mind that dividend progression from cyclical sectors, such as mining, can be erratic. Food and technology sectors were also good sources of income growth while several struggling retailers have been forced to cut their dividends.  

I have previously highlighted the reasonable valuation of the UK market, which offers one of the highest yields among developed countries.The FTSE 100 is at a two year low on a forward PE (price to earnings ratio) of under 10x, with over a third of its constituents having a dividend yield in excess of 5%. Furthermore, a good chunk of revenues derive from international earnings ensuring geographical as well as sector diversification.

Ultimately, dividends can only be paid if companies are generating the earnings to cover them and analysts keep a close eye on the dividend cover ratio. However, recent earnings reports have been encouraging and, while there is no guarantee this will continue, dividend cover for UK stocks is actually expected to improve next year.

Understandably, some sectors have higher yields than others; these may be mature, low growth but stable businesses, for example utilities. The important thing is to avoid ‘dividend traps’ which are companies in structural decline or with weak management which may lead to dividend cuts. An experienced income fund manager will conduct in-depth analysis of a company’s financial strength, cash-flow characteristics and future prospects.

Funds for income seekers

Many funds balance high yielders with lower yielding growth stocks which have scope to grow dividends above average. A well-diversified portfolio is essential as not all areas perform well at the same time.

In the UK Income sector, Columbia Threadneedle UK Equity Income Fund, currently yielding 3.9%, has a flexible approach with the current focus being on large, blue chip companies which are out of favour.

Woodford Equity Income, with a yield of 3.5%, has gone through a period of weak performance as Mr Woodford has stuck to his contrarian strategy. A play on the domestic economy, with exposure to unlisted and small cap stocks making it a higher risk option, this fund offers recovery potential.

Looking further afield, Artemis Global Income, with a 3.1% yield, adopts a value seeking strategy while Fidelity Global Dividend, offering a 2.7% yield, focuses on defensive companies with high quality earnings streams.

The road ahead for equity income

In most countries (the US being the notable exception) stock markets currently offer a superior income to government bonds, a situation that once would have been thought inconceivable. Furthermore, bonds are vulnerable to erosion by inflation and offer no scope for growth in income or capital returns. Thus, with the advent of pension freedoms, dividends paid by companies may be a solution for retirees in drawdown who don’t want to buy an annuity.

Merian Global Investors have done some interesting research which shows that over time dividend payments tend to follow a far smoother path than stock market indices. Merian attributes this to the conservatism of company directors; they are reluctant to cut dividends when profits fall (understanding their importance to many investors) yet when profits rise they are cautious about increasing them too quickly in case the upturn is not sustained. 

What are the prospects for dividends? Admittedly, the extended economic upturn has to end at some point but this does not mean we are in for a deep recession; the pace of expansion may slow but an imminent collapse in profits seems unlikely. As for the impact of Brexit and trade wars, any consequences are just speculation at this juncture.

Dividends partly reflect a company’s financial position and what it has achieved to date but their growth, or the reverse, is also widely considered to be an indicator of confidence about the future. Strong balance sheets with cash reserves and continued conversion of profits into cash suggests dividends should continue to be well underpinned and investors seeking income should feel reasonably comfortable about the year ahead.