A blanket approach to large cap dividend-paying stocks is sucking cautious investors into companies with shaky earnings forecasts, according to Thomas Moore, manager of the Standard Life Equity Income trust.

Moore (pictured) has been shifting the focus of the trust onto mid and small cap stocks since he took over in November of last year and says a belief that certain blue chip stocks are overbought is a central theme. 

FE Trustnet has previously carried warnings about the growing risk to investors from the amount of money pouring into a few big dividend-payers, and Moore says these fears are well-founded. 

"The concentration risk if a left-field event hits the sector could be extreme. We’ve already seen serious unexpected events in the banking sector in 07/08 when they cut their dividends and we saw a similar event with BP. There’s a clear benefit to having dividends more spread." 

He explains that the large cap defensives favoured by UK Equity Income funds have weaker potential for increasing their dividends, and several have suffered earnings downgrades in recent months. 

This means investors seeking income would be better served by mid and small cap stocks with strong growth potential, which would support future dividend yields. 

"There are powerful reasons people aren’t selling those defensive stocks, but they should be asking why they are holding companies that are suffering earnings downgrades like Vodafone," Moore added.

Data from FE Analytics shows Standard Life Equity Income's share price has underperformed its sector average since Moore took over in November, returning 7.22 per cent to investors, although its NAV has grown by 10.94 per cent. 

Performance of trust vs sector since Nov 2011



Source: FE Analytics

The discount is partly due to an unexpected sell-off by one major investor over the summer; however, Moore says this makes it the perfect time to buy into the trust. 

The portfolio has become less concentrated since the manager took over and currently has 48 per cent of its assets under management in its top-10, compared with 53.5 per cent for the benchmark. 

Moore has also cut its exposure to certain equity income favourites such as Vodafone. 

"We have reduced our holding but it’s still 9.2 per cent, which perfectly captures the dilemma we have: how can you avoid such a large part of the market with a yield of 7.5 per cent?" 

"We hope to reduce our holding further in future as we find smaller alternatives." 

Moore explains that Vodafone is suffering from over-exposure to the eurozone and potentially from industry changes that make the products it sells – such as data deals – cheaper and cheaper.

One of his largest underweight sectors is the mining industry, which he says is an example of a consensus view leading to trouble. 

"Mining companies got caught out by believing in the super-cycle too long and there are examples of them now being over-exposed, having started too many mines. We don’t hold much in mining companies, as they are a big macro bet." 

Steve Russell of the Ruffer Investment Company told FE Trustnet in August that he feared a bubble was forming in IMA UK Equity Income, but Moore says although he agrees with the thrust of the warning, the sector still has some advantages. 

"I wouldn’t say it’s a bubble, because it depends on what you are looking for as a manager. If you are an income manager you can still see the case for putting money in stocks yielding 4 per cent. If you are an asset allocator like Ruffer then perhaps it’s different." 

"I would say that maybe the bubble is in government bonds, not in those stocks, which at least have strong earnings and balance sheets behind them."