If you haven’t heard anything about the growing concerns surrounding the outlook for the UK dividend market then, in the words of former Leicester City manager Nigel Pearson, “you are an ostrich”. 
The possibility of significant income reductions from some of the FTSE’s largest names is quickly becoming one of the most talked about subjects within the financial pages, which is understandable given the ongoing search for yield thanks to years of ultra-low interests rates and the fact that the population is getting older.
Falling commodity prices, diminishing levels of dividend cover due to poor earnings growth and structural challenges facing some of the UK’s dividend stalwarts have all contributed to the bearishness.
Numerous market commentators have also warned that these dividend cuts won’t be limited to natural resources stocks either, with the likes of Neil Woodford, Thomas Moore and analysts at various broker firms warning of reductions right across the FTSE 100 index.
Indeed, on Friday aero engine giant Rolls-Royce announced a 50 per cent dividend cut and said profits would be at the lower end of forecasts.
Given the concentrated nature of the index (the likes of BP, Shell, AstraZeneca, GlaxoSmithKline, British American Tobacco, HSBC and BHP Billiton have accounted for close to 40 per cent of the total dividends paid over recent years) and the fact that so many rely on the domestic equity market for income, there is seemingly plenty to be worried about.
Michael Clark, manager of the £1bn Fidelity Moneybuilder Dividend fund, agrees that – on the face of it – there are plenty of reasons for investors to move away from the IA UK Equity sector at the moment.
Clark, whose fund has been a top quartile performer and nearly doubled the gains of the FTSE All Share since he took charge in July 2008, is one member of his peer group who prioritises income and yield.
Fidelity MoneyBuilder Dividend’s income history
Source: FE Analytics *figures based on a £10,000 investment in January 2009
FE data shows, for example, that his fund is comfortably top quartile for income pay-outs since he has been at the helm and has even managed to grow his fund’s dividend in each of the last seven years.
He wants to maintain that return profile, but in order to do that he says he has to ignore large parts of the index.
“We will definitely see areas of the market where dividends are under pressure throughout 2016. Prioritising dividend sustainability will be crucial for income investors. I am happy to be completely out of some sectors, such as mining, even though share prices have collapsed,” Clark (pictured) said.
“I remain cautious on the oil and gas majors as dividends that looked challenged at $70-80 oil are seriously under threat at an oil price of $30. There are also still question marks on the ability of banks in state ownership to grow dividend payments as they face the prospect of paying out further compensation for miss-sold payment protection insurance.”
In this article, therefore, he highlights three of his favourite stocks that believes have a very dependable and sustainable dividend.
Legal & General
“I have recently initiated a position in financial conglomerate Legal & General,” Clark said.
“L&G operates in (and in some cases dominates) markets that provide strong long-term structural growth. The group has adapted to negative developments in the individual annuity market by increasing capital allocation to the bulk annuity market where returns are attractive and barriers to entry are high.”
“International expansion should increasingly present opportunities as L&G seeks to replicate its de-risking proposition in the US and other markets.”
According to FE Analytics, L&G has been caught up in the recent market volatility as its share price has fallen more than 25 per cent since December. Nevertheless, Clark says it is a great option for genuine income investors.
Performance of stock versus index over 1yr
Source: FE Analytics
He added: “This is a cash generative business, with a strong dividend yield (5.5 per cent). I expect the group to sustain circa 10 per cent growth in dividends for the next three years.”
FE data shows that 20 other IA UK Equity Income funds count Legal & General as a top 10 holding, which makes up roughly a quarter of the index. They include the likes of CF Woodford Equity Income, Threadneedle UK Equity Income and Majedie UK Income.
Capita
Next up is Capita, the FTSE 100 support services and outsourcing giant, which Clark says perfectly matches his investment style.
“[Capita] is consistent in its delivery of profits versus expectations and a company that rarely disappoints, fitting well with my philosophy of investing in ‘safety of income at a reasonable price’,” he said.
“It is a dominant player in its markets with high barriers to entry, high visibility and a strong management team that can identify new opportunities, with exposure to the UK and Germany. The company has a solid mid-single digit organic growth profile with further potential for 5 per cent growth from acquisitions, offering a compound annual growth rate of circa 10 per cent in earnings.
He added: “Capita also has strong cash conversion and the dividend yield of 3 per cent is well-supported.”
As the graph below shows, Capita is a stock that has consistently rewarded investors over the past 10 years and while its share price has fallen over recent months, the falls are not as large as the index as a whole.
Performance of stock versus index over 10yrs
Source: FE Analytics
Interestingly, there are only two IA UK Equity Income funds that count Capita as a top 10 holding – M&G Dividend and Santander Dividend Income Portfolio.
Severn Trent
Last but by no means least is Severn Trent, which Clark believes is a very attractive option for those seeking dividend growth.
“Severn Trent is a regulated utility. As OFWAT sets the parameters for regulation on a five-year cycle, there is good visibility of returns on this company,” Clark said.
Interestingly, Severn Trent was one of a number of FTSE stocks that had to cut its dividend recently after OFWAT announced it would force water companies to reduce water bills for consumers in January last year. Thought the shares fell on the news, the stock has far outperformed the FTSE 100 since the start of last year.
Performance of stock versus index since Jan 2015
Source: FE Analytics
Now the dividend cut has happened, Clark says there is no reason not to hold Severn Trent.
“I look for safety in the form of predictability – companies where I can make a credible projection of the returns a company will make. In a stable regulatory environment the regulated utilities are ideal investments for an income strategy as they also pay a reliable dividend,” he explained.
“Severn Trent currently yields over 3.5 per cent. Consolidation is also likely to occur in this sector, and has already begun with Pennon’s takeover of Bournemouth Water in 2015. The larger players such as Severn Trent stand to benefit if they can drive out efficiencies from such deals.”
Possibly as a result of its dividend cut, though, no funds in the IA UK Equity Income currently hold Seven Trent in their top 10.
