Concerns have been on the rise about the future of the UK equity income sector given the very concentrated nature of the FTSE All Share and these were compounded earlier this week thanks to findings from the Capita UK Dividend Monitor.
The report, which is published quarterly, found that while UK dividends hit a record £27.2bn in the third quarter of 2015, there was an increased chance of slower dividend growth next year as a number of leading stocks (such as Standard Chartered and Glencore) have reduced their pay-outs and as dividend cover in the FTSE All Share has fallen to its lowest point in six years.
The Capita UK Dividend Monitor also noted that there are likely to be further pay-out cuts in the year ahead, especially by companies which focus on international trade.
The six large-cap stocks that the report said was most at risk of cutting over dividends over the next year or so were BHP Billiton, Rio Tinto, Anglo-American, BP, Royal Dutch Shell and HSBC and as the table below shows, five of them are popular holdings within the IA UK Equity Income sector.
While no funds in the 84-strong peer group count Anglo American as a top 10 holding, 7.14 per cent hold BHP Billiton, 19.04 per cent hold Rio Tinto, 34.25 per cent hold BP, 44.04 per cent hold Shell and 47.64 per cent hold HSBC.
Source: FE Analytics, Bloomberg and Miton
On top of that, research from FE Trustnet found that 66.61 per cent of IA UK Equity Income funds hold at least one of those five stocks, 48.01 per cent hold at least two and 26.19 per cent hold at least three in their top 10.
Therefore, we took a closer look at the funds which generate the highest proportion of their current yields from those companies in question. In order to do that, we looked at the proportion the stock made up of the total portfolio and multiplied that figure by the company’s dividend yield, then divided that by the fund’s current yield.
It must be noted that it isn’t an exact representation as we used each fund’s most recent factsheet but the company’s dividend yield as of yesterday. Nevertheless, it gives a very good indication of how much these fund’s rely on these possibly troubled companies for their income.
One area of particular concern, according to the Capita UK Dividend Monitor, is the mining sector after the huge falls in commodity prices over recent years.
Performance of indices over 3yrs
Source: FE Analytics
While it said BHP Billiton and Rio Tinto have both reaffirmed their intention to continue their progressive dividend policies, it pointed out that the financial position of the mining groups has worsened markedly this year.
According to FE Analytics, there are six funds within the sector which count BHP Billiton as a top 10 holding and further 19 which have a large stake in Rio Tinto. The fund which is arguably most at risk to a dividend cut in the mining sector is SJP UK Income.
The £90m fund is headed up by FE Alpha Manager Chris Reid and our data shows that while he holds 9.22 per cent of his portfolio in BHP and Rio, he generates a hefty 15.17 per cent of his current 4.01 per cent yield from the two stocks.
Given the SJP UK Income fund is based on Reid’s now soft-closed Majedie UK Income fund, it is no surprise to see the latter also has 14.72 per cent of its current yield dependent on the two mining giants.
The substantial fall in the oil price has had huge ramifications across the world, not least in regards to uncertainty about the sustainability of the likes of BP and Shell’s future dividend.
The Capita UK Dividend Monitor felt that much of the concern about Shell’s pay-out has been massively overblown, especially as it hasn’t reduced its pay-out since the Second World War and as the management team has been cutting costs.
Nevertheless, there are worries about the company given the oil price is expected to remain at its current level for some time to come and its dividend cover is very low.
FE data shows that out of the 37 funds which hold Shell in their top 10, there are three which rely on more than 10 per cent of their current yield from the stock – namely Scottish Widows HIFML UK Equity High Income, Halifax UK Equity Income and Insight Equity Income.
The report was also concerned about the future of BP, noting that its management will need to follow in Shell’s footsteps and “resist pressure to reduce its own pay-out”.
As the table below shows, nine out of the 29 IA UK Equity Income funds which count BP in their top 10 rely on the stock for at least 7 per cent of their current yield. The fund which is most exposed is UBS UK Equity Income, as the stock makes up 11.28 per cent of its income.
The fund also generates 6.33 per cent of its yield from Shell and 6.7 per cent from Rio Tinto.
Source: FE Analytics
While the huge falls in the price of oil and other commodities has been well-reported, the Capita UK Dividend Monitor also warned that other commonly held stocks may be at risk of cutting their pay-out.
“Just as commodity dividends are under pressure from the downturn in China, so other stocks exposed to emerging markets are feeling the pinch,” it said.
“Standard Chartered has cut its pay-out, knocking approximately £500m from 2016. It is now reportedly mulling a large rights issue which could amount to as much as the last three to four years’ dividends. Even HSBC’s pay-out may be vulnerable too, though we are not pencilling in any reductions for now.”
HSBC is the most frequently held stock out of the five mentioned in this article in the equity income sector, which comes as little surprise as it is the largest listed company in the UK with a market cap of £97bn.
However, FE data shows more funds rely on its current 6.10 per cent dividend yield than others. The fund which is most exposed to it from that point of view is JOHCM UK Equity Income, which is managed by Clive Beagles and James Lowen.
The £2.6bn fund, which carries five FE Crowns, generates 9.53 per cent of its current 4.3 per cent yield from the stock.
In fact, JOHCM UK Equity Income is the only fund in the sector to hold BHP Billiton, Rio Tinto, BP, Shell and HSBC as top 10 holdings, meaning that a hefty 36.91 per cent of its yield is dependent on those five stocks.
The fund has been one of the sector’s best performers over the longer term, beating its FTSE All Share benchmark by 60 percentage points since its launch in November 2004.
Performance of fund versus sector and index since launch
Source: FE Analytics
The fund had been renowned for its high weighting to mid-caps, but due to the now substantial valuation differential on offer, Beagles and Lowen have been rotating the portfolio towards the mega-cap end of the index.
At the recent JOHCM investor day, Beagles said he had been buying more of the likes of HSBC, Rio Tinto and BP over recent months.
The fund has also performed very well from an income perspective, as a recent FE Trustnet article highlighted, paying out the fifth highest amount to its investors over the past five years – generating £2,877.94 on an initial £10,000 investment.
As the chart below shows, JOHCM UK Equity Income has increased its dividend in every calendar year since launch except in 2009 following the global financial crisis.
JOHCM UK Equity Income’s dividend history
Source: FE Analytics
While there are clearly risks involved with buying the likes of Rio Tinto, BHP Billiton, BP, Shell and HSBC, if none of them were to cut their dividends next year it is likely the fund’s income pay-out is will increase.
Aside of the JOHCM fund, there are seven IA UK Equity Income funds which hold four of the five companies mentioned in this article in their top 10. They include Barclays UK Equity Income, Lazard Multi Cap Income and R&M UK Equity Income.
