The overwhelming demand for income is proving detrimental to some UK businesses, according to Schroders’ Nick Kirrage, who says that fund managers’ insistence on companies’ maintaining their dividend could be damaging their future prospects. 
Kirrage, who co-manages the Schroder Income and Schroder Recovery funds with Kevin Murphy, says it is damaging for some businesses to continue to paying out a dividend when they have run into financial difficulties but argues that some are doing so because they know fund managers insist on receiving their payouts.
“There is little income fund investors hate more than seeing their income cut. They may forgive, say, a 20 per cent or 30 per cent fall in an individual stock holding but they are likely to be a good deal less merciful about a 2 per cent or 3 per cent drop in a dividend pay-out,” the manager said.
“Their cash distributions are important to them – after all, there is a good chance they will be living off them.”
He points to UK aerospace and defence specialist Cobham, which Schroder Income has a small position in, as an example of this. The firm issued its second profit warning in the space of six months on 29 April; on the same day it asked investors to back a £500m rights issue intended to prevent the debt it took on to finance a series of acquisitions in 2014 from bumping up against its banking covenants.
Performance of stock vs index over 3yrs
Source: FE Analytics
While Kirrage has “one-off concerns” over Cobham’s debts, acquisitions and covenants, he does not worry particularly that it is suffering from a broad-based slowdown at the moment. However, he adds that “the real red flag” over the business is that it intends to pay a dividend even after announcing a £500m rights issue.
“Think about that for a moment,” the manager said. “What it means in practice is the company wants to take money off its investors today to help it pay down debt and then return a chunk of it to them in the form of dividends – roughly £90m later this year and £120m in 2017. Even before you factor in the tax that will be payable on the dividends and all the fees that will be due on the rights issue, how does that make sense?”
“Well, take a look at the company’s register and it certainly begins to – because then you will see that many of Cobham’s biggest shareholders are income funds. So while it may make no economic sense to plough on with a dividend, the fact is that, were the business to do the rational thing and cut its own pay-out, then those funds would probably have to cut theirs.”
Kirrage suspects that businesses’ awareness of needing to keep income investors happy is one of the reasons they insist on maintaining dividends, even if this is not the most sensible course of action. He notes that Cobham is not the only company ever to consider persisting with its dividend in the wake of a rights issue as others such as National Grid and Rexam have done something similar in recent years.
“Letting the income fund tail wag the corporate dog, however, is not how things should work – even if, given the size of the income fund space in the UK, that tail is now worth some £80bn,” Kirrage said.
“We accept it might sound odd to hear income fund managers suggesting companies should not feel they need to maintain their dividends at a certain level. But note the word ‘fund’ in that sentence. As managers of equity portfolios, we understand some businesses will do well and others less so and, in an income context, some will be forced to cut dividends while others will grow theirs.”
“Furthermore, we are not just income fund managers, of course – we are value investors and we do not like to see the sort of value leakage that occurs from giving money to a company through a rights issue only to see it later returned minus tax and fees. Eating into Peter’s capital account to pay Paul’s income may serve to avoid an unwanted conversation with some investors but it raises the prospect of another, equally awkward, chat with those who take a similar view to this issue as us.”
Since Kirrage and Murphy took over the £1.5bn Schroder Income fund in May 2010, it has generated a 69.60 per cent total return against a 53.75 per cent rise in the FTSE All Share. It has also outperformed the average fund in the IA UK All Companies sector but is slightly behind the IA UK Equity Income sector, where it used to reside.
Performance of fund vs sectors and index under Kirrage and Murphy
Source: FE Analytics
An investment of £10,000 made at the start of this period would have paid out just over £2,750 in income since and the fund is currently yielding 4.39 per cent.
The managers’ approach has won them fans among investment analysts, with Square Mile Investment & Consulting awarding the fund an ‘A’ rating.
The consultancy 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. This may be painful in the short-term for investors but these times may mark the periods when the strategy has the greatest opportunities ahead of it.”
Schroder Income has a clean ongoing charges figure (OCF) of 0.91 per cent.
