Focusing on yield-paying stocks has become a popular strategy among UK investors recently, due in no small part to the fact that the average fund in the IMA UK Equity Income sector has outperformed the FTSE All Share by close to 10 percentage points over three years.
Performance of sector vs index over 3yrs
Source: FE Analytics
Investors in the sector will be pleased to hear that according to Capita’s Dividend Monitor, UK corporates will pay out £30bn more this year than they did in 2013.
The report says that one of the major reasons for this surge is Vodafone’s planned £16.6bn special dividend, which will be the largest in UK corporate history. Underlying dividend growth is also expected to be better in 2014 than it was in 2013.
However, as FE Trustnet highlighted recently, the rate of underlying dividend growth slowed in the third quarter of last year and as a result the group had to revise down its expectations for 2014 by £800m.
Last year was the first time that total annual dividends contracted since 2010. The amount paid out fell by 1 per cent between 2012 and 2013.
That was due to the fact that the likes of Vodafone and Cairn Energy did not repeat their 2012 special dividends. Actual underlying dividend growth was better in 2013 than it was the year before, even though the rate of growth began to slow.
Justin Cooper, chief executive officer of shareholder solutions at Capita Asset Services, says that although last year may have been slightly disappointing for equity income investors, this year is likely to see a pick-up in earnings.
Many experts have said this is what is necessary to support the recent re-rating in equity markets, and Cooper says it should also be beneficial for underlying dividend growth.
“UK dividends ended 2013 with a whimper,” Cooper said. “Sustaining the stellar dividend growth of 2011 and 2012 was always going to be difficult, but in the event, 2013 has been a harder year for income investors than expected. Growth is still there, but it has been slowing sharply.”
“Dividends lag the earnings cycle for obvious reasons – companies have to make the profits before they can pay them – so we are only penciling in fairly modest growth for the year to come, but 2014 will be buoyed by Vodafone’s huge payout. This will make 2014 a record year.”
Ben Willis (pictured), head of research at Whitechurch, is a fan of using equity income funds and says the demand for them will only continue to grow in the near-term. “It has been an unbelievably popular asset class and there have been a number of factors that have driven that,” he said.
“The main reason is because of the ultra-low levels of interest you can get from other areas of the market. The prospect for bonds doesn’t look good as there has been a 30-year bull run which has sped up since the period after the financial crash.”
According to FE Analytics, the average fund in the IMA UK Gilt sector has returned 275 per cent since the start of our data in December 1989. Those returns had been almost uninterrupted until recently when yields began to rise.
Performance of sector since Dec 1989
Source: FE Analytics
Willis says that equity income has been growing in popularity as yields on bonds have dipped, and the rate of growth in equity payouts means it is unlikely investors will be able to get an equivalent yield from fixed interest for some time to come.
“Ten-year gilt yields are around the 3 per cent mark at the moment, but there will always be that cross-over between bond and equity yields where one looks more attractive than the other,” Willis said.
“However, Capita is forecasting dividend yields to be 4.2 per cent, so if people were to wait for bond yields to catch up, then they would be hit by some significant capital losses,” he added.
While there is a clear demand for income, a number of fund managers – such as JOHCM’s Ben Leyland – say that the current obsession with yield is holding back the economic recovery, as companies are being forced to pay out dividends instead of investing for growth.
Willis sympathises with this idea, but he says investors have no reason not to hold equity income funds.
While he says the yield available from equity income is far better than it is possible to find elsewhere in the market, he adds that these funds will also protect capital more effectively this year if earnings growth fails to pick up at the necessary rate.
“Equity income is a great starting point for investors,” Willis said.
Performance of sector vs index over 1yr
Source: FE Analytics
“Markets have clearly had a very good year, but that has all been about price re-ratings, with small caps being the only area where earnings growth has been slightly positive. We need earnings growth, because without it, the market looks toppy.”
“With that uncertainty, equity income funds look attractive as you can take a position and effectively bank a 3 or 4 per cent return from the yield.”
“You don’t have to take the income either, as we use equity income funds in our core capital growth portfolios and just keep rolling up the income,” he added.
In an article tomorrow morning, Willis will tell FE Trustnet which core UK equity income fund he is using in his portfolio to replace the ones that Neil Woodford currently runs.