In today’s world of low interest rates and volatile market conditions, investors continue to be drawn towards the income-generating and defensive characteristics of equity income. 
But while the IA UK Equity Income sector continues to attract assets, it is also making headlines following the removal of several high profile funds for failing to meet the inclusion criteria.
This has led to calls for the Investment Association to overhaul its yield requirement which states that funds need to provide a distributable income of at least 110 per cent of the FTSE All Share by investing a minimum of 80 per cent in UK equities.
The argument here tends to focus on the fact that the overall yield of the All Share is skewed by around 30 large-cap stocks which yield in excess of 5 per cent. Given this, some market participants have suggested that the IA is forcing equity income funds to invest in these high yielders and prioritise absolute yield over the potential for future dividend growth.
I take the opposite view. Indeed, I believe that UK equities offer ample opportunity to generate a sustainable and growing income stream.
As the chart below shows, the Fidelity MoneyBuilder Dividend Fund continues to comfortably meet the IA sector threshold and today provides investors with a yield of more than 3.8 per cent.
Fund’s yield history versus the index
Source: Fidelity
Notably, the fund’s distributions have been generated solely from the natural income of the underlying holdings and not from capital – with the fund’s capital base actually growing ahead of inflation.
This is important as it not only protects clients underlying investment from the pitfalls of rising prices, but also means that the fund has consistently been able to grow distributions to shareholders in each of the last three years.
Safety of income at a reasonable price
For me, the key to striking a balance between income generation and capital growth is quite simple – invest in high quality fundamentally robust companies with simple business models and predictable and consistent cash flows.
I favour these types of companies as I believe they are best placed to deliver sustainable dividend growth across the market cycle.
I term this approach ‘safety of income at a reasonable price’ (SIRP). Placing so much emphasis on the sustainability of a company’s income stream – and its ability to grow this over time – means that I don’t necessarily own the highest yielding stocks in the market.
History shows high yield can often be a sign of stress in the underlying business and so I will not own any stock just because of its yield if I feel uncomfortable with the investment thesis which underpins it.
Looking at markets today, the mining sector is case in point. The portfolio has very limited exposure to this segment despite companies such as BHP Billiton, Anglo American and Glencore all yielding more than 5 per cent and mid-cap name Vedanta yielding around 10 per cent.
Performance of indices over 5yrs
Source: FE Analytics
The cash flow in mining companies is very cyclical. So I would invest, if at all, in the company with the lowest costs, the best balance sheet, and the widest spread of commodities, and even then only after a sell-off in the price.
This is almost certainly not the company with the highest yield.
Opportunities in some less obvious areas
My preference for large-cap blue chip stocks – coupled with the concentration of yield in the UK market – means that the fund is biased towards FTSE 100 companies.
However, the size and diversity of the UK market means that fundamental research can uncover selective opportunities further down the market-cap spectrum. Examples of this would include insurance companies that trade through the Lloyd’s platform, like Amlin, Beazley and Hiscox which I regard as attractive dividend and total return plays.
These companies are very strong dividend payers as they write insurance business to a combined ratio of claims to costs of 85 to 90 per cent, with the 10 per cent to 15 per cent difference paid back to investors in the form of a dividend.
Outside of these insurance names, I would also highlight Cranswick, which is a supplier of premium, fresh and added value food products. It is a mid-cap stock that is highly cash generative and pays an attractive dividend with prospects for dividend growth.
Performance of stock versus index over 3yrs
Source: FE Analytics
These examples help confound popular thinking and highlight that the UK offers dividend growth potential across a range of areas.
What’s more, by investing in solid companies that are able to sustain and grow dividend payments across the cycle, I believe the Fidelity MoneyBuilder Dividend Fund is well positioned to continue to deliver exactly what an equity income fund should – an attractive and growing income stream and above-inflation capital growth, with relatively low levels of risk.
Michael Clark is the manager of the £1.1bn Fidelity MoneyBuilder Dividend fund.
Since he took charge of the fund in July 2008 the fund has been a top quartile performer in the IA UK Equity Income sector with gains of 91.57 per cent, beating the FTSE All Share by close to 35 percentage points in the process.
A recent FE Trustnet article highlighted that Clarke has grown his fund’s dividend in each of the last five calendar years.
All the views expressed above are his own.