It has never been more important to consider diversifying away from the concentrated and seemingly at-risk UK dividend-paying market, according to Neptune’s George Boyd-Bowman. 
Concerns about the largest income payers in the FTSE 100 have been on the rise over the past six months or so with numerous reports suggesting that 2016 will bring a raft of dividend cuts.
The reasons for this include the fact that earnings growth has waned and dividend cover has fallen but, more importantly, the huge falls in commodity prices recently has put pressure on the natural resources-biased UK index.
For example, the likes of Glencore and Anglo American have had to cut their dividends while there are now big concerns surrounding BHP Billiton’s dividend which currently yields more than 10 per cent.
Boyd-Bowman – manager of the Neptune Global Income fund – though, is worried about the future of BP and Shell now that the oil price has fallen to below $40 a barrel.
A recent FE Trustnet study highlighted that 34 per cent and 44 per cent of IA UK Equity Income funds hold BP and Shell in their top-10 respectively, and Boyd-Bowman says now is the time for investors to take some of their money out of the concentrated market.
“I have to be careful here as you would expect a global equity income manager to tell you that you need to diversify out of your UK income funds, but actually, there has never been a more important time to really consider this,” Boyd-Bowman (pictured) said.
“That is because of this idea of dividend sustainability. In the UK, just 15 stocks account for two thirds of all dividends. In fact, just two stocks account for a quarter of all dividends paid and they are BP and Shell.”
Performance of stocks versus indices in 2015
Source: FE Analytics
“Now, that’s all fine in a period of high and rising oil prices but in a period like today of low and falling oil prices, that starts to question dividend sustainability. There has always been the need to diversify your asset allocation and income stream away from the UK, but it is so much more pressing today.”
Of course, there are many managers in the UK equity income space who are avoiding natural resources companies at the moment and therefore the sector can’t be viewed as a homogenous group.
Nevertheless, a recent report from Canaccord Genuity noted that there is likely to be an “epidemic” of earnings downgrades and that the trend will not just be limited to the hugely out-of-favour sector.
“Yes, energy (aka oils) and materials (largely mining) are down due to depressed commodity prices, but the trend in cash flow returns is also negative in healthcare, consumer staples (i.e. food products, beverages, tobacco and food retail), utilities and telecoms. That’s a big proportion of the market,” the report said.
Colin Morton, who is the longest serving manager in the IA UK Equity Income sector having taken over his Franklin UK Equity Income fund in 1995, says investors are right be cautious on UK dividends. He warns that not only do the commodity companies look troubled, but the likes of GlaxoSmithKline, Vodafone and HSBC all have potentially challenged dividends.
“At best, we will see a lot of big companies with stretched dividends. At worst, we are going to see a lot of big dividend cuts,” Morton said.
Given his views on the UK market, Boyd-Bowman has a very different portfolio to many of his peers.
FE data shows, for example, that his is close to 20 percentage points underweight the US at the moment relative to his MSCI World benchmark, marginally underweight Europe ex UK and has just 10 per cent in the UK. That UK exposure only includes five stocks and they are less popular holdings such as Devro, the sausage skin maker.
“My exposure to UK listed stocks fit mostly into our “dividend special situations” silo of the fund. These stocks are chosen as we believe there is a catalyst for the dividend to start growing, or start growing more quickly. I don’t own the old stalwarts or “mega traps” of a typical UK income fund such as HSBC, Glaxo, BP, and BHP Billiton,” he said.
His biggest overweight, therefore, is Japan as he holds 23 per cent of Neptune Global Income in the region.
This willingness to be different has hindered returns, though, as his fund (which yields 3.88 per cent) is some 9 percentage points behind his benchmark since its launch in December 2012. It is outperforming the IA Global Equity Income sector over that time, however.
Performance of fund versus sector and index since launch
Source: FE Analytics
Nevertheless, Boyd-Bowman thinks Japan will be the best hunting ground for income investors over the longer term.
“We believe that Japan has the best prospects for dividend growth over the next decade,” Boyd-Bowman.
“In fact, dividend pay-out ratios in Japan are just 30 per cent whereas here in the UK they are 60 per cent. If you believe, like me, that dividend pay-out ratios are going to rise up to UK levels over the next 10 years, then all things being equal, Japan is no longer going to be viewed as an unusual place to look for income. In fact, it should become a dividend aristocrat market.”
The reasons he likes Japan are due to Prime Minister Abe’s economic policies, which have been dubbed ‘Abenomics’. The first two ‘arrows’ of Abenomics (monetary and fiscal reform) have so far been successful as corporate profitability doubled, the yen has weakened and unemployment is at 17-year low.
While the jury is still out on the ‘third arrow’ of structural reform, Boyd-Bowman notes that there are some encouraging signs regarding a change in corporate governance which is leading to a better dividend culture in Japan.
Investors will no doubt have realised that Japan hasn’t had much of a dividend culture in the past and this is partly reflected by the yield on offer from the IA Japan sector relative to other regional peer groups.
Source: FE Analytics
“Japan has always had the ability to pay higher dividends, it’s just never had the willingness to do so,” Boyd-Bowman said.
The manager points out the largest 1,900 companies in the Japan have combined a ¥80trn (£650bn) of cash on the balance sheet – which is equivalent to an economy the size of Switzerland – but the country’s corporate sector has always been very non-shareholder friendly.
The introduction of the Nikkei 400 is starting to change this however, according to Boyd-Bowman.
“It’s generally agreed that this movement has been kicked off by the launch of the Nikkei 400, the first index to have a return on equity threshold, and since then we have seen the stewardship code introduced and the corporate governance code.”
“To cut a long story short, these reforms are making companies more shareholder friendly. Dividends are no longer a low priority for Japanese companies.”
Boyd-Bowman says concrete evidence of this change comes in the form of Amada, the mega-cap manufacturing firm, which was ‘shamed’ by not being included in the Nikkei 400 due to poor corporate governance.
The president of the company was so incensed by this decision he doubled the company’s pay-out ratio and initiated a share buy-back programme. However, the manager says Amada is still not part of the index as the regulators want to see more shareholder-friendly policies.
Boyd-Bowman added: “Japan is the developed market with the best prospects for the strongest dividend growth in the world over the next 10 years. Japan has always had the ability to pay higher dividends, it just hasn’t had the willingness.”
“But, when you combine the two it creates an incredibly powerful and potent cocktail for dividend growth. That’s what gets us excited and we think there is a very long way to go with this story as pay-out ratios are extremely low from a global perspective.”
In an article later today, FE Trustnet will take a closer look at the top-rated funds which derive the majority of their income from Japan.
