While finding a growing source of income is the key aspect for equity income investors, the first task is to identify businesses that have a decent level of dividend cover as it means you know the amount of income you receive isn’t likely to drop.
UK investors will usually turn to FTSE 100 mega-cap names for the core of their income portfolio – which makes sense given that dividends from the index accounted for close to 90 per cent of the total UK dividend-paying market in 2013.
However, Standard Life’s Thomas Moore warned FE Trustnet yesterday that mega-caps such as GlaxoSmithKline, BP and Shell – which are held by a very high proportion of IMA UK Equity Income funds – may be forced to cut their dividends due to weak oil price, in the case of BP and Shell, and falling sales in the case of GlaxoSmithKline.
“These well-held mega caps are facing top-line pressure which requires a significant cost-cutting response to maintain dividends at current levels,” Moore said.For income investors who are concerned about that potential risk, Miton’s Gervais Williams says they should turn to smaller companies.
Williams, manager of the CF Miton UK Multi Cap Income fund, says that while smaller companies may be more volatile than their large-cap rivals from a total return point of view, if investors purely want income they are the best place to be.
“Generally, smaller companies have much better dividend cover than large caps,” Williams (pictured) said.
“During the boom years most investors didn’t expect much in the way of dividends from these stocks. However, given the renewed interest in equity income, many smaller companies are now boosting their dividend payments to shareholders.”
“Smaller companies are consistently bucking the trend, because they have lesser market positions so even small additional increments of market share can add up to decent growth. Many UK smaller quoted companies also have little debt so they don’t have competing interests for their cashflow.”
While it might be expected for Williams to talk-up his own asset class (he also manages the CF Miton UK Smaller Companies fund) research from Charles Montanaro, manager of the Montanaro Equity Income fund, backs up his statement.
Using data from Numis, Montanaro showed that the 12-month trailing dividend cover on the Numis Smaller Companies index is 2.7 times, while the FTSE All Share – which is 80 per cent weighted to the FTSE 100 – has dividend cover of 1.9 times.
Indices’ 12 month trailing dividend cover
Source: Numis and Montanaro
While the outlook for smaller companies may look uncertain, we look at three funds within the IMA UK Equity Income sector which shy away from the large-cap household names and instead generate their yield from a predominately small-cap portfolio.
PFS Chelverton UK Equity Income
One such example is the five crown-rated PFS Chelverton UK Equity Income fund, which is co-managed by David Taylor and David Horner.
The £340m fund is more than 70 per cent invested in companies that have a market-cap of below £1bn.
Data from FE Analytics shows it has been one of the best funds in the sector for income over the seven full calendar years.
It has paid out £313.8 on an £1,000 made on 1 January 2007 while the sector average has paid out £287.1p; ranking it eleventh in the sector over that time for income earned. As part of our income campaign, it should be noted that the team at Chelverton publish their dividend history on their factsheet.
It has also performed very well from a total return point of view. Though it struggled during the financial crisis, FE data shows it has been the tenth best performing fund in the sector over seven years with returns of 51.9 per cent, beating the FTSE All Share by more than 20 percentage points.
Performance of fund vs sector and index over 7yrs
Source: FE Analytics
It has been top decile over three and five years, but has struggled in this year’s flat market.
PFS Chelverton UK Equity Income has a yield of 4.16 per cent and an ongoing charges figure (OCF) of 1 per cent.
Marlborough Multi Cap Income
Siddarth Chand-Lall’s Marlborough Multi Cap Income is one of the newest entrants to the IMA UK Equity Income sector, as it was launched in July 2011.
However, it has proven an immensely popular holding with investors as its AUM has already surged to £935m.
It is a highly diversified portfolio made up of 133 stocks and Chand-Lall has 34.4 per cent in mid-caps, 34.8 per cent in small-caps and 22.2 per cent in micro-caps – which are companies with a market cap of below £250m.
It has paid out £178.23 in dividends on a £1,000 investment made at launch. It paid out £47.6 on £1,000 in 2012 and £59.8 in 2013.
However, the group does not show its dividend history on the fund’s factsheet.
It has taken full advantage of the recent rally in equities as, over three years, it has been the sector’s third best performer with returns of 74.74 per cent, beating the sector average by more than 30 percentage points.
Performance of fund vs sector over 3yrs
Source: FE Analytics
It yields 4.58 per cent and its OCF is 0.8 per cent.
Unicorn UK Income
The five crown-rated Unicorn UK Income fund is one of the oldest multi-cap funds in the sector as it was launched in May 2004.
The portfolio had been run by FE Alpha Manager John McClure until his death earlier this year.
It is now managed by Simon Moon and Fraser Mackersie, who have been “fully indoctrinated” into the John McClure process.
When the fund was growing larger, McClure had started to dip into FTSE 100 names.
However, the now £600m fund has very minimal exposure to the large-caps following outflows on the back of McClure’s death and the underperformance of mid and small caps over recent months.
The rest of the portfolio is split across the FTSE 250, Small Cap and AIM indices.
Investors who bought £1,000 of units in Unicorn UK Income 10 years ago would have since earned £604.84 in income.
Like Marlborough, Unicorn doesn’t publish dividend history on its factsheet.
The fund has been the best performing portfolio in the IMA UK Equity Income sector since launch with returns of 228.82 per cent, beating its FTSE All Share benchmark by more than 100 percentage points.
It has also been top decile over three, five and seven-year periods, but has been the sector’s fourth worst performing portfolio over 12 months with losses of 3.79 per cent.
Unicorn UK Income has an attractive 5.35 per cent yield and its OCF is 0.81 per cent.
