Dividend cuts are a real source of frustration for income investors as not only do they obviously receive less of a pay-out, but the share price of that company is almost guaranteed to fall as a result.
This is why concerns about the UK market have increased over recent months as there are fears that 2016 is likely to bring more dividend cuts (around 10 FTSE 100 stocks have already cut this year) as pay-out ratios seem unsustainably high and dividend cover has fallen considerably.
Two reports over the past few months have highlighted these dangers, one of which was the Capita UK Dividend Monitor which suggested that some of the most popularly held income-paying stocks (such as HSBC, BP, Shell, Rio Tinto and BHP Billiton) may have to cut dividends unless internal or external factors improve.
The other report was put together by Canaccord Genuity’s Alan Brierley and Ben Newell, who warned the market (not just commodity-related companies) is facing an “epidemic” of earnings downgrades.
Dividend cover on the FTSE 100
Source: Canaccord Genuity Quest
“And it’s worth noting that the stream (or should that be torrent?) of downgrades is not just a sudden realisation that 2015 expectations will not be met. The downgrades are even more severe for 2016. The median downgrade across the whole market is 2 per cent and in most sectors there is a higher proportion of downgrades for [2015] than [2016],” Brierley and Newell said.
In truth, given they have to pay out all the income they receive every year, there are very few IA UK Equity Income funds which have managed to consistently grow their dividends over the longer term.
One exception to the rule, however, is Hugh Yarrow and Ben Peter’s five crown-rated Evenlode Income fund.
Not only has it been one of the sector’s highest income-producing funds since its launch in October 2009 (it has paid out £3,117 on an initial £10,000) but it increased its pay-out in 2009, 2010, 2011, 2012, 2013 and 2014. While we don’t have data for the fund’s final two payments of this year, it also looks likely to increase its dividend again in 2015.
Evenlode Income’s dividend history
Source: FE Analytics
The £292m fund has also been top decile in the sector both total returns and its maximum drawdown, which measures the most an investor would have lost if they had bought and sold at the worst possible times.
Yarrow, though, is concerned about the UK market both from total return and dividend points of view going into next year. 
“Profit warnings and dividend cuts have been on the rise in the UK, particularly for stocks with exposure to the energy, industrial metals and capital goods sectors,” Yarrow (pictured) said.
“Companies closer to the consumer are in general fairing relatively better, but even for these businesses life is not particularly easy. At the same time, the valuation environment is not as attractive as it has been.”
“In my view, UK equities are priced to deliver lower returns over the next five years than they have been over the previous five years.”
Performance of index over 5yrs
Source: FE Analytics
He added: “The outlook for dividend growth also looks lower due to rising pay-out ratios, with the outlook for dividends particularly compromised in the capital-heavy resources sector.”
In order to maintain his dividend growth, the manager is avoiding certain areas of the market completely, mainly capital-heavy sectors including energy and mining producers due to the clear threats they face in the form of low commodity prices.
“Our focus as we head into 2016 is (as usual) on asset-light companies with strong free cash flow,” he said.
“We are also attracted to companies that benefit from repeat-purchase business models. These characteristics tend to help produce more sustainable dividend streams. Key sectors for the fund include consumer branded goods, support services, healthcare, software, media and speciality engineering companies.”
Of course, though, some of these ‘asset-light businesses’ have been among the most popular with investors in the years since the global financial crisis due the reliable earnings (and therefore dividends) they offer.
One of the best examples is the consumer goods sub-sector, which has outperformed the FTSE Al Share by more than three times over the past five years leaving many of its constituents (such as Unilever and Diageo) on what many perceive to be as very high valuations.
Yarrow and Peters currently hold 34.2 per cent of their portfolio in consumer goods companies with the likes of Unilever, Diageo, Johnson & Johnson and Procter & Gamble featuring in their top 10 – all of which has boosted their fund’s performance over the years.
They are, though, cognisant of the risks involving these stocks over the shorter term – given their valuations and the likelihood of higher interest rates – so are focusing more on other parts of the market heading into the New Year.
“In the uncertain economic and market environment of the last two years, some high quality businesses with operational momentum have seen very strong share price performance, leading to compression in their dividend yields and forward return potential,” Yarrow said.
“This trend means we are most interested at present in quality businesses with short-term operational headwinds – such as currency headwinds or an industry slowdown – where valuations are looking more attractive as a result.”
Yarrow says there are a number of stocks that fit this criteria, but two of his favourites are Spectris and Jardine Lloyd Thomson.
He points out that Spectris, which operates in the precision instruments and controls sector, has fallen out of favour due to a slowdown in global industry.
However, he says that with earnings and dividend growth at 10 per cent per annum and dividend yield of 3 per cent which is more than twice covered by free cash flow, he was happy to buy the shares following their underperformance over recent months.
Insurer Jardine Lloyd Thomson (JLT), on the other hand, has been hit by a swathe of headwinds such as a decline in insurance rates and the changes to the UK pension system. However, Yarrow has also been upping his exposure.
Performance of stocks versus index over 6 months
Source: FE Analytics
“However, JLT is taking market share in this downturn, taking advantage of lower insurance rates to increase coverage for clients, and driving growth in new sectors such as cyber insurance,” he said.
“JLT’s annual dividend growth over the last five years has been 7 per cent and the latest increase was 5 per cent. The potential for healthy dividend growth over coming years is good, and the current dividend yield is 3.5 per cent.”
