The risk of dividend cuts from some of the UK’s biggest payers coupled with the potential for some companies to return to the income-paying register means finding a “dividend picking” manager is more important than ever, according to Schroders’ Nick Kirrage.
Last year proved to be a relatively strong one for UK income investors, with payouts totalling £87.6bn over the year in spite of some high profile cuts. The latest Capita Dividend Monitor notes that headline dividends were down 10 per cent on the previous year, although 2014’s bumper payout was due to the record special payment made by Vodafone.
UK dividend history
Source: Capita Dividend Monitor
It was the dividend cuts of 2015 that dominated the headlines, however, with supermarkets lowering payouts after a price war ate into profits and plunging commodity prices hit the miners and oil firms.
During the year, Tesco cancelled its payment altogether, while WM Morrison and Sainsburys sharply reduced theirs, and cuts were made by the likes of Standard Chartered, Centrica and Tullow Oil.
That’s not to say the worst is over as many market commentators expect high-profile cuts to continue or even intensify over the coming 12 months.
“Dividend cuts have made the headlines in 2015, but the greatest impact is yet to come,” the Capita Dividend Monitor said this week.
“The picture for dividends is very mixed. Indeed, we are far less certain about the outcome for the year ahead than we have been for several years. Some very large UK-listed firms have slashed their payouts lately and there may be more bad news to come. Meanwhile, currency effects continue to add considerable volatility to UK payments.”
Furthermore, the group has sharply revised down its dividend forecast for the next 12 months. In October, it expected a total of £89.8bn to be paid out in 2016 – which would have been 2.5 per cent higher than 2015 – but has just cut this to £86.5bn – which would mean a fall of 1.3 per cent at the headline level.
It is also predicting underlying dividends, which exclude special dividends, to fall by 0.9 per cent to £83.8bn. If this were to come about, it would represent the first fall for underlying dividends since 2010.
Kirrage, co-head of the global value team at Schroders and co-manager of the £1.4bn Schroder Income fund, agrees that the outlook for dividends is challenging over the near term. He points out that dividend growth has been “well above” historical averages in recent years but argues that it will be a struggle for this to continue.
However, this does not mean that the manager believes the picture is overwhelming negative for income investors, even if they have to work harder from this point on.
Income earned on an initial investment of £10,000 under Kirrage and Murphy
Source: FE Analytics
Kirrage, who has grown Schroder Income’s dividend payout in every full calendar year he and co-manager Kevin Murphy have been at the helm, said: “We're kind of in a place where it's time for dividend pickers. We talk about stock pickers but it is dividend pickers that investors need now.”
“I think people are obsessing about who is going to cut but I think a question that could be more important is who is going to come back. With banks, you're sat there looking at the stocks and core tier 1s in those businesses are getting up to 15 per cent now. There are a lot of headwinds, absolutely, but that is a natural yield sceptre.”
“A big part of the dividend outlook will come from companies returning to the register. Income investors will want to be involved in these while avoiding those that will be cutting.”
An example of how important companies returning to the dividend register came about last year, when Lloyds resumed paying dividends in February. Analysts say the bank, which stopped payouts after being bailed out by the taxpayer in the financial crisis, has the capacity to pay generous dividends in the future.
Laith Khalaf, senior analyst at Hargreaves Lansdown, said: “Market forecasts suggest Lloyds could pay a dividend of 4.7p for 2016 and 5.5p the year after, offering a yield of 5.75 per cent, rising to 7.3 per cent in 2017 at today’s market price of 64p.”
This means Lloyds Banking Group has become increasingly popular with managers. FE Analytics shows that 18 of the 83 funds in the IA UK Equity Income sector now count the bank as a top 10 holdings, with Majedie UK Income having the biggest holding at 5.88 per cent.
Kirrage also points out that there are a number of value plays in the UK equity market. Mining companies like Rio Tinto and BHP Billiton have seen yields jump to double-double digit levels after plunging commodity prices caused a drop in investor sentiment.
Performance of stocks vs index over 3yrs
Source: FE Analytics
Of course, companies in these sectors are some of those considered to be at risk of dividend cuts. But Kirrage argues that this should not mean they are ruled for investors with a high enough risk tolerance.
“For those who are willing to be a bit braver, where a company is already yielding 14 per cent if it cuts its dividend by 70 per cent it still yields more than the market. So as the stock market looks to discount - and it is a discounting mechanism - there may be an opportunity,” he said.
“Everybody is desperate to wait for that last minute where someone gives them the thumbs up and tells them it'll be alright to invest now. But you're rewarded for being brave so in individual instances you need to invest where you have conviction.”
Since Kirrage and Murphy took over Schroder Income in May 2010, the fund has posted a 47.35 per cent total return, ranking it third quartile in the IA UK All Companies sector where the average gain has been 55.06 per cent. It has outperformed its FTSE All Share benchmark, which has risen 43.99 per cent over this time.
It must be noted that the fund has a value approach to investing and that this style has been heavily out of favour over recent years, although commentators are increasingly argued that this is likely to reverse – at some point.
Square Mile, which gives the fund an A rating, said: “The equity income strategy deployed by Mr Kirrage and Mr Murphy is a credible one which should add value over the longer term. Investors should note that a contrarian approach such as this does tend to be more volatile than other equity income strategies.”
Schroder Income has a clean ongoing charges figure of 0.91 per cent and yields 4.16 per cent.
