This hasn’t normally been an issue, though, as the list of the FTSE’s mega-cap constituents is littered with industry leading companies with strong franchises, reliable earnings and well-covered dividends.
However, regular FE Trustnet readers will have no doubt seen that concerns have been raised about the outlook for four of the biggest contributors to the UK dividend paying market – GlaxoSmithKline, BP, Royal Dutch Shell and Vodafone – as the mega-caps could well be forced to reduce their pay-outs if either their businesses don’t improve operationally or the market they reside in continues to face headwinds.
“What is scary about those four companies – BP, Shell, GlaxoSmithKline and Vodafone – is when you put them together, they make up around 25 to 30 per cent of all the dividends the UK market pays,” Franklin’s Colin Morton said.
FE data has shown how popular those four companies are within the IA UK Equity Income sector, as just 17.9 per cent don’t hold them within their top 10.
Source: FE Analytics
Due to requests from a number of our readers, in this article we take a closer look at those 15 funds which make up the 17.9 per cent.
As can be imagined, a large proportion of those funds are the sector’s smaller cap income funds such as Unicorn UK Income, Marlborough Multi Cap Income, CF Miton UK Multi Cap Income, PFS Chelverton UK Equity Income and Elite Webb Capital Smaller Companies Income & Growth.
Clearly, there are other risks involved with buying funds that plunge the depths of the FTSE All Share for opportunities, such as the possibility of heightened volatility and illiquidity.
Nevertheless, as an FE Trustnet article pointed out last year, investors can find much higher levels of dividend cover in smaller companies than they can in the FTSE 100.
In the article, Standard Life Investment’s Thomas Moore predicted that the likes of BP, Shell and GlaxoSmithKline could all be forced to cut their pay-outs over the coming years as they face “top-line pressure which requires a significant cost-cutting response to maintain dividends at current levels”.
As a result, Gervais Williams of CF Miton UK Multi Cap Income and Charles Montanaro, manager of Montanaro Equity Income, said smaller companies were becoming the natural home for income investors.
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: Montanaro/Numis
Most of the small-cap income funds in the sector, as well as comfortably outperforming the wider market over recent years due to their style bias, are also very well-diversified from portfolio and income points of view.
The likes of the CF Miton, Marlborough and PFS Chelverton funds have between 80 to 130 holdings while their top 10 positions only account for 20 per cent or less of their total assets – suggesting that their dividends are not overly reliant on just a few stocks.
However, even Unicorn UK Income, the most concentrated small-cap income fund from a portfolio point of view, has a relatively diverse income stream.
According to FE Analytics, the five crown-rated fund’s list of top 10 holdings account for 41.7 per cent of its total assets, but only 24.8 per cent of its 5.62 per cent yield is generated by those companies. This means that co-managers Simon Moon and Fraser Mackersie generate meaningful amounts of income from the large majority of their holdings.
Just to note, the way to calculate how much a stock’s dividend accounts for a fund’s total income stream is to multiply its weighting within a portfolio by its dividend yield, then divide that figure by the fund’s yield.
On top of that, that 24.8 per cent is evenly spread as Moon and Mackersie’s largest individual contributors to their income stream are Marstons and Interserve, which only each make up 3.5 per cent of their fund’s total dividend.
Outside of the smaller companies funds, there are a selection of genuine multi-cap income funds that don’t hold BP, Shell, Glaxo or Vodafone in their top 10.
The best examples are the top-performing Ardevora UK Income and Majedie UK Income funds. However, though both funds avoid those four mega-caps, it doesn’t mean they don’t have dividend risk associated with them.
In the case of the four crown-rated Ardevora fund, manager Jeremy Lang has a relatively unique approach to the market which revolves around cognitive psychology and the belief that people in financial markets – be it company management teams, analysts or investors – are prone to making predictable mistakes, errors of judgement or biases.
He then tries to exploit those mistakes to create opportunities. It means the fund is built from a stock perspective first, then a yield perspective second as he will own some companies that don’t pay a dividend and some that do.
Therefore, in order to make sure his fund hits the sector’s yield requirement, Lang holds more in the dividend paying stocks.
This is shown by data from FE Analytics as while his top 10 stocks make up 42.78 per cent of Ardevora UK Income’s assets, they actually generate 47.4 per cent of his fund’s total dividend.
The example is even more extreme in the case of FE Alpha Manager Chris Reid’s five crown-rated Majedie UK Income fund.
One of Reid’s biggest themes at the moment is financials as he thinks they will benefit from an improving UK economy. However, given that most banks aren’t huge dividend payers at the moment, he owns financials such as insurers and asset managers.
Reid’s top 10 holdings account for 38.1 per cent of his assets, however, as insurance names such as Direct Line Insurance, Friends Life, Phoenix Group and Aviva – which were hit hard by the chancellor’s pension changes – feature on that list, his top 10 positions actually generate 61.1 per cent of his total yield.
Majedie UK Income’s top 10 holdings in terms of assets and income
Source: FE Analytics
For example, Friends Life makes up 4.3 per cent of his assets but it produces 11.5 per cent of his fund’s income. The reason for that is because the stock’s dividend yield is 8.5 per cent – and the reason that is so high is largely because the dividend cover is just 1.2 times.
Phoenix Group is another stock with a high dividend yield (7.3 per cent) but dividend cover of below 1.3 times, according to data from Hargreaves Lansdown.
There are other more esoteric funds to feature in those 17.9 per cent of IA UK Equity Income funds that don’t hold BP, Shell, Glaxo and Vodafone and a good example is Elite Charteris Premium Income – which has historically had a high weighting to natural resources stocks as its manager, Ian Williams, also runs the WAY Charteris Gold & Precious Metals fund.
While the fund avoids some of the sector’s most popular stocks, 21.45 per cent of its total income is generated by three mining stocks – Rio Tinto, BHP Billiton and Antofagasta.
Elite Charteris Premium Income, as a result of that positioning and other factors, is also the worst performing portfolio in the sector over one, three and five years.
Another interesting fund to feature on the list, however, is Craig Rippe’s £120m CF Canlife UK Equity Income fund as while it doesn’t hold the four stocks mentioned in its top 10, it is a large-cap portfolio.
The fund, which yields 3.8 per cent, counts the likes of BT Group, Imperial Tobacco, HSBC, Prudential and British American Tobacco as top 10 holdings. Nevertheless, its full portfolio isn’t published so it could well be the case the fund has BP, Shell, Glaxo and Vodafone as smaller holdings.
It has also underperformed the FTSE All Share and the sector over three, five and 10 years, however.