It is clear that income will remain a popular theme for years to come as interest rates are set to stay low while the population is only getting older.
However, while investors have increasingly turned to the UK equity market for their primary income stream, concerns have ramped up surrounding the outlook for the domestic dividend paying market.
While most of those worries have been concentrated on commodity-related stocks (which do make up a fairly large proportion of the UK’s total dividends), other reports have suggest the trend is far more widespread.
One such piece of research was put together by Canaccord Genuity, which found that while the yield on UK large-caps stands at 4 per cent, total net income has fallen from £171bn to £138bn in the past five years, while dividend cover has fallen from 2.7 times to 1.6 times.
As the graph below shows, UK income streams have effectively stalled since 2011 as earnings growth has slowed.
The UK equity market’s dividend history
Source: Canaccord Genuity Quest
As such, Investment Trust Intelligence, a quarterly report published by Kepler Partners, has considered the likely retreat in equity income shares and identified the UK equity income investment trusts that are – for those who are truly bearish on the outlook – most heavily defended against such a scenario.
To whittle down the list, the report used the Kepler Income Ratio – a proprietary measure that shows the resilience of a trust to a shock to its underlying portfolio income – to identify the trusts it thinks are best placed in what is likely to be a difficult period.
First up is the JP Morgan Claverhouse Investment Trust, which features on the AIC’s list of ‘dividend heroes’ due to its 42 years of consistent income growth.
Investment Trust Intelligence says the future of the trust – which is managed by William Meadon and Sarah Emly and focuses on FTSE 350 stocks – is also attractive given its reserves.
“The trust has grown its dividend for 42 consecutive years and offers a net dividend yield of 3.3 per cent, backed up by sufficient reserves to pay the full dividend for more than a year even if underlying portfolio income were to dry up completely,” the report said.
“Our analysis using the Kepler Income Ratio shows that these reserves are sufficient to cover any statistically likely shortfall in the trust’s underlying income more than four times over. Dividend cover has grown steadily since 2010, after it was depleted during the 2008 financial crisis.”
For example, the trust paid out a dividend of 12.45p in 2005 and that has steadily increased to 21.5p last year.
Meadon joined Emly as co-manager of the trust in February 2012, over which time it has outperformed both the IT UK Equity Income sector and its FTSE All Share benchmark with gains of 50.88 per cent, according to FE Analytics.
Performance of trust versus sector and index under Meadon & Emly
Source: FE Analytics
Its largest holdings do include some challenged stocks, though, such as Lloyds, Royal Dutch Shell, BP and HSBC, which is reflected in its 8 per cent discount to NAV. This is wider than its one and three-year averages.
JP Morgan Claverhouse has ongoing charges of 0.75 per cent (excluding a performance fee) and is geared at 14 per cent.
Next is this trust, run by Thomas Moore – a manager who is becoming increasingly popular thanks to his open-ended fund’s track record.
Like Standard Life Investments UK Equity Income Unconstrained, Moore takes an all-cap approach in his trust and favours a growing dividend over a high headline yield. Investment Trust Intelligence says this is a prudent strategy in the current environment.
“The trust offers a net dividend yield of 3.2 per cent, slightly behind the median yield for the AIC UK Equity Income sector. It has, over the last ten years, built up its revenue reserves steadily and as at the end of December 2015, has revenue reserves equivalent to 77 per cent of its full dividend for the year, after the final dividend is taken into account.”
“Given the shifting strategy, into more of an ‘all-cap’ portfolio, the Kepler Income Ratio tells us less than it should given the limited read-across from the historic pattern of earnings generated by the trust.”
“As such it is difficult to interpret the reserves standing at 2.8 times a ‘one standard deviation’ shortfall in income, given the variability of income could be greater or lesser than the historic pattern when the trust had more of a large-cap bias.”
Moore took charge of Standard Life Equity Income in November 2011 over which time he has been able to gradually grow his dividend. The trust has also comfortably outperformed both its peers and the wider market under Moore’s guidance, as the graph below shows.
Performance of trust versus sector and index under Moore
Source: FE Analytics
Currently, Moore holds 34.8 per cent in the FTSE 100, 46.4 per cent in the FTSE 250, 5.6 per cent in the FTSE Small Cap index and 13.2 per cent outside of the index.
Standard Life Equity Income is trading on a slight premium to NAV, though, having historically traded on a discount. It’s geared at 1 per cent and has ongoing charges of 0.94 per cent, making it cheaper than Moore’s open-ended fund.
While not one of the sector’s most exciting propositions, Investment Trust Intelligence rates Simon Gergel’s Merchants Trust for genuine income investors given its impressive dividend record (33 years of growth) and the resilience of that dividend.
Unlike many of its peers, the trust almost solely invests in FTSE 100 stocks which were the epicentre of most concerns surrounding the future of the UK dividend market.
However, though the yield is higher than 5 per cent thanks to the use of covered call options, Gergel’s stock-picking skills and strong revenues mean it is one of the safest dividends out there, according to the report.
“The trust markets itself on the back of the attractive yield it generates, making heavy use of its dividend record in its literature, and the board has taken care to build up a strong revenue reserve equivalent to almost two years of dividends.”
“Given the volatility of the trust’s underlying portfolio income historically, the Kepler Income Ratio shows that these reserves are enough to cover any statistically probable shortfall more than ten times over.
“Given the level of dividend cover in place, the strong Kepler Income Ratio, and the pressure that the board is under to make sure the trust’s 33-year record of dividend increases is not sullied, we feel that the dividend is about as secure as it gets.”
Gergel took over the trust in April 2006 and over the past 10 calendar years Merchants’ dividend has increased from 19.4p to 28p.
According to FE Analytics, Merchants has narrowly underperformed relative to its peer group average (largely due to its mega-cap bias) under Gergel but has beaten its benchmark with gains of 41.46 per cent.
Performance of trust versus sector and index under Gergel
Source: FE Analytics
Its top 10 holdings include GlaxoSmithKline, BP and BAE Systems. The trust currently trades on a 2.9 per cent discount to NAV, is geared at 22 per cent and has ongoing charges of 0.62 per cent – which is one of the lowest in the peer group.
