Investors would be wrong to sell their core UK equity income funds in the current environment, according to Fidelity’s Michael Clark (pictured), who argues that the recent criticism of the sector is unfounded. 
A number of leading industry experts have warned FE Trustnet about the outlook for large-cap UK equity income funds over recent weeks with headwinds such as the possibility of rising bond yields, expensive valuations and the risk of further dividend cuts all adding to the negative sentiment.
Indeed, the likes of Margetts’ Toby Ricketts and Mark Harris at City Financial have been selling down their exposure to the asset class as a result of those concerns.
However Clark, manager of the £1.1bn Fidelity Moneybuilder Dividend fund, disagrees with the bad press which has been directed at his sector as he believes traditional IA UK Equity Income funds will continue to perform well.
“It is fair to say we are still finding plenty of opportunities to generate yield from the equity market,” Clark said.
“We are still in this situation which has persisted for a long time where you have very low yields on fixed income and yet significantly higher yields in the equity market – and that hasn’t changed despite the volatility that we have seen in the bond market over the past month or two.”
“I think it is also fair to say that most dividends are well supported by cash flow. There have been a few cuts in the past year but these have been isolated events and are not the sign of a general trend.”
He added: “Management teams are generally focused on conservative balance sheets, limited debt and strong cash flow, all of which are good for us and good for dividends.”
One of the major bearish arguments towards large-cap dividend paying stocks is scepticism about the outlook for future income pay-outs.
Earlier in the year Franklin’s Colin Morton warned that four of the largest income payers in the UK market – GlaxoSmithKline, Vodafone, BP and Royal Dutch Shell – all have “challenged dividends” and could be forced to cut if either the industries they reside in see an uptick or their businesses don’t improve operationally.
FE Alpha Manager George Godber took this argument a step further.
He pointed out that while six FTSE 100 stocks had already cut their dividend this year – Centrica, Tullow Oil, Tesco, Sainsbury’s, Severn Trent and Morrisons – he expected many more to follow suit over the coming 12 months.
Performance of stocks in 2015
Source: FE Analytics
However, Clark says those concerns are overblown.
“Although the dividend pay-out ratio has crept up over recent years, it is very much below the long-term average. This is a positive and supportive environment and it shows that companies are being run conservatively.”
“It’s another way of saying corporate balance sheets are in good shape.”
The Fidelity manager also questions why his peers are avoiding large-caps from a valuation point of view, given that average yields on offer on the FTSE 100 (3.4 per cent) are 90 basis points higher than the FTSE 250 and FTSE Small Cap indices’ yields following the strong outperformance of smaller companies over the past five years.
Performance of indices over 5yrs
Source: FE Analytics
“In terms of where the yield is in the market, it’s still very much in larger companies. We remain very much focused on FTSE 100 companies as we want to generate a superior yield and superior dividend growth,” Clark, whose fund yields 3.62 per cent, said.
Another argument against buying large-cap dividend paying companies is because many of them are viewed as ‘bond proxies’.
The reason for that is because blue-chips in industries such as consumer staples, utilities and pharmaceuticals have very reliable earnings and the perceived safety of their dividends has meant their share prices’ have been bid-up by more cautious investors.
Certain experts say this now presents a problem as their fortunes will be closely correlated to the performance of fixed income. Bond yields have already spiked over recent months, but many – such as FE Alpha Manager Martin Walker – expect this trend to continue and they therefore say that defensive large-cap stocks are in for a tough period of underperformance.
“It has really been those bond-like equities which have really been driving the market over the last few years and in terms of sectors I would include FMCG [fast-moving consumer goods], regulated utilities but also large-cap pharmaceuticals,” Walker said.
“Fund managers’ Pavlovian reaction to a market that he or she is getting twitchy about is to run to defensive shares, that’s the instinct in all of us. However, I think that is the worst thing you can now do – in fact I think it is a trap.”
However, Clark is ignoring this argument and currently has a high weighting to those high quality, more defensive, companies.
“We are still very much focused on pharmaceuticals as I believe it is a sector which will continue to do well over the next three to five years. Telecoms also, particularly fixed-line, I think is a strong area. Consumer goods, industrials and regulated utilities still very much have their place,” Clark said.
Clark currently holds the likes of GlaxoSmithKline, Imperial Tobacco, Royal Dutch Shell and Reckitt Benckiser as top 10 holdings.
Source: Fidelity
The major reason for that is not because he thinks now is a good time to be invested in less economically sensitive stocks, but the chances are a drastic collapse in the bond market are very low.
“Interest rates may rise a little bit but the key point is I don’t see a damaging squeeze on rates in past periods where we have seen rate increased. We don’t expect a squeeze like we saw in the early 1990s or in the 1980s or anything like that and the simple reason for that is inflation isn’t there.”
He added: “Any interest rate rises will be moderate which I think is supportive for us and supportive for the market.”
Clark has managed the four crown-rated Fidelity Moneybuilder Dividend fund since July 2008. According to FE Analytics, it has been a top-quartile performer over that time with returns of 101.85 per cent and has beaten the FTSE All Share by 25 percentage points.
Performance of fund versus sector and index since July 2008
Source: FE Analytics
While the fund’s large-cap bias means it has lagged the sector in rising markets, it has come into its own in more turbulent ones such as in 2011 when the European sovereign debt crisis intensified.
This is shown in its capital preservation characteristics as it has been top quartile for its maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – since Clark took charge.
Fidelity Moneybuilder dividend has an ongoing charges figure of 0.67 per cent.
