A less concentrated dividend-paying market, potentially higher levels of future income and a strong recovery in earnings growth are among the major reasons why UK investors need to diversify into European income funds, according to Argonaut’s Oliver Russ.
Investors are often told about the importance of a diversified income stream, but while that is certainly the case, UK funds have smashed their regional rivals over the years in terms of reliable and high dividends.
However Russ, who manages the five crown-rated Argonaut European Enhanced Income fund, says that is starting to change.
He has managed his £107m fund, which is one of only a few in the IA Europe ex UK sector to offer hedged currency share classes, since its launch in April 2010 over which time it has been a top-quartile performer and comfortably beaten its benchmark with returns of 63.71 per cent.
Performance of fund versus sector and index since launch
Source: FE Analytics
The fund is also top quartile and ahead of the index over one, three and five years.
While Europe has been among the major sources of bad news for global markets over recent months thanks to the Greek debt negotiations, Russ says there are a number of factors why genuine income investors need to move at least part of their money from the UK and onto the continent.
“Everyone knows about UK equity income, which has done a sterling job over recent decades and there is absolutely no reason why people shouldn’t continue to invest in that. But equally there is absolutely no reason why you can’t do exactly the same in continental Europe,” Russ said.
“In fact, there might be one or two reasons why it might be easier to do in continental Europe than in the UK.”
Europe offers a lot more in terms of diversification
Firstly, Russ points out that there is a huge range of diversification within the Europe ex UK space in terms of regions, economies and currencies. More simply, as well, there are a whole lot more income producing stocks to choose from in Europe than in the UK.
While the UK has the highest proportion – 25 per cent – of ‘high dividend’ yielders (more than 3.5 per cent) in the whole European market, there are three times as many stocks in the remaining European markets.
However, he also points out that there are 11 European income funds chasing the remaining 75 per cent of companies while there are more than 80 funds in the IA UK Equity Income sector and a handful more funds which have recently switched to the IA UK All Companies sector while still chasing those 25 per cent of stocks.
“The biggest single market [in Europe] is the UK, but there are three times as many dividend paying stocks in Europe ex UK. On the other hand, the number of UK equity income funds chasing those stocks is around 100, while there are about a dozen European income funds,” Russ said.
Given that dynamic, and the fact a very large proportion of the UK’s total dividends are paid by a small selection of mega-caps (BP, Shell, AstraZeneca, GlaxoSmithKline, British American Tobacco, HSBC and BHP Billiton account for 35 per cent of all UK dividends), he says investors need to be aware of just how concentrated the IA UK Equity sector is.
Source: Argonaut Capital Partners
As the table above shows, for example, 93.4 per cent of funds in the sector own GlaxoSmithKline, 83.6 per cent own HSBC and 80.3 per cent own Royal Dutch Shell.
Could well offer higher levels of income as a result
Not only is the UK market concentrated, though, but there are concerns about the future dividends of some of the index’s largest income generators.
Standard Life Investments’ Thomas Moore discussed this theme in a recent FE Trustnet article, as he pointed out that dividend cover within the FTSE 100 has fallen substantially over recent years to just 1.5 times as earnings per share growth has weakened.
Dividend cover of indices over 20yrs
Source: Datastream
“I suspect we are going to have some pretty bad news coming out of some of the largest companies in the UK market in the coming months,” Moore said.
Those which are seen as having potentially risky dividends include GlaxoSmithKline, BP, Shell and Vodafone.
Russ says this could present an issue for investors, but could also mean that investors generate more income from their European fund than their UK equity income stalwart.
“The UK’s [concentration] not necessarily a problem, but what we have found out over the last five years or so is that there is no such thing as a blue-chip anymore – just look at what happened to RBS, Tesco or BP.”
“All of them have had nightmares over the past few years so the more diversification you can get the better, especially as I don’t think you have to give up any income to go into Europe – it’s quite the reverse actually.”
While Russ has the ability to use covered call options within his portfolio to boost income, his fund has paid out more in the way of dividends than popular UK funds such as Invesco Perpetual High Income, Artemis Income and Threadneedle UK Equity Income since its launch.
Income earned on £10,000 since April 2010
Source: FE Analytics
His fund currently yields 3.67 per cent and Russ says his use of call options haven’t materially benefitted given that markets have gone up in a relatively straight line over recent years. It must be noted though that Argonaut fund’s income pay-outs have been quite lumpy, as the dividend has been cut in two out of the last five years.
Europe is in genuine recovery mode
The final point is that the outlook for European dividends seems to be improving, as Russ says earnings have hit an “inflection point” which should lead to better dividend cover and in turn could mean better dividend growth.
While the ECB’s quantitative easing (QE) package has acted as a driver for both markets and sentiment towards the region, Russ says that there is a genuine economic recovery happening as well.
“This year, so far is fundamentally different as we are holding about 12ish per cent earnings growth and Q2 reporting season seems like it is going to be the best in terms of earnings surprise in about five years.”
He therefore points out that investors can afford to be more bullish on Europe (which has significantly lagged the UK market since the global financial crisis) despite concerns over Greece, which caused volatility earlier in the summer.
Performance of indices since the global financial crisis
Source: FE Analytics
“In isolation, I’m quite bullish on Europe actually because this is the first time in about four or five years that we have seen positive earnings growth and the whole Greece thing is a massive side-show in my opinion,” he said.
“Does it really matter whether Greece is in or out of the eurozone? It’s a fraction of the economy either way and so really it is a political decision rather than an economic one. Obviously, people are worried about potential contagion but now the ECB is standing behind with QE.”
The experts’ view
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, says investors are right to turn towards European funds for dividends given the potential risks facing the IA UK Equity Income sector.
“Yes I do agree. Some of the earnings trends for larger dividend payers in the UK are rather worrying – and not just in the obvious energy and commodities space. Dividend cover has been falling, in other words earnings have fallen but dividends maintained or grown, and there are now real risks of cuts,” Morgan said.
Other highly-rated European income funds, apart from Russ’s portfolio, include BlackRock Continental European Income, Invesco Perpetual European Equity Income and Schroder European Alpha Income.
However, Morgan says investors shouldn’t become overly reliant on the region given its history of nasty shocks.
“Equity income should therefore cast their net as wide as possible to include better value areas and would definitely include Europe in this. A lower euro is helping drive recovery in earnings, but it should be remembered that large parts of Europe, like the UK, are internationally orientated, so the issues of Chinese slowdown and US interest rate rises will have an impact,” Morgan said.
He added: “Interesting, yes, but not a panacea.”
