Investors in UK equity income funds should beware looming dividend cuts and snowballing high yield traps, according to FE Alpha Manager Mark Barnett , who believes the year ahead will be a disappointing one for the market as whole.
At nearly a month into 2016, the equity market seems to have somewhat calmed down from the heady volatility seen in the first few weeks of the year.
Performance of index in 2016
Source: FE Analytics
Barnett (pictured), who as head of UK equities at Invesco Perpetual and sole manager of the three open-ended funds and four investment trusts meaning he runs the most money of any equity income manager in the UK space, points out “it is hard to make sense of the day-to-day moves.”
Striking a bearish tone, Barnett says the recent turmoil in China has brought about a strong realisation that many companies in the FTSE 100 are being hit by a strong bout of deflationary pressure.
This coupled with a lack of earnings growth is a mounting problem for their potential pay outs, he warns.
“The reason many companies are struggling to grow earnings is lack of top line growth and part of that is due to pricing. When you break down earnings it is volume and price and if price is negative or zero it is tough to grow your top line,” Barnett said.
“So if you ally that with the fact that earnings growth will remain difficult and given the environment we are in: there is earnings disappointment around the corner.”
“Also, a number of areas have been conspiring to make equities look less attractive - partly valuation and partly levels of earnings growth which is linked to valuations.”
He thinks there is also a growing danger that investors are becoming attracted by higher yielding stocks hit by the recent selling in global markets.
“If you buy something that looks like a high yielding stock, be very careful that the yield is sustainable. The recent question marks around dividends will continue and we will see more dividend cuts come through in different areas of the market that have previously been seen to be quite safe.”
“The concentration of dividend payments in the market is pretty high. The market is heavily concentrated in market caps terms, dominated by four very large sectors but actually when you look at the concentration of the dividends it is different to the market cap but is equally highly concentrated.”
“So, it worth bearing in mind, the yield from the market is not equally distributed. So when you're looking at the yield of the market and how safe it is, dividend payments are going to be much more closely scrutinised partly due to the earnings picture.”
His thoughts are echoed by Eric Moore, manager of the Miton Income fund, who warned yesterday there are a number of potential yield traps in the UK market – most specifically in the bombed-out resources space.
“These yields are high because the market 'knows' that they are unsustainable. And without a massive rally in commodity prices, unsustainable is exactly what they are,” Moore said.
Performance of indices in 2015
Source: FE Analytics
“The risk is that as 2016 unfolds, the major resource companies move from a 'progressive dividend policy', where they seek to nudge the dividend along year-in, year-out to a policy more clearly based on a pay-out ratio. This would probably be sensible.”
“A progressive dividend policy in a cyclical industry is always eventually going to run into trouble. But moving to a pay-out ratio-based policy, where the companies pay out, say, one-third of earnings, maybe with a teaser of special dividends if balance sheets are strong, would see some pretty ferocious dividend cuts.”
In particular, Barnett warns the hazardousness of the market is most evident in the pay-out ratio of the market – which measures the amount of earnings paid out to shareholders - is looking increasingly unsustainable.
“The pay-out ratio in the market has increased quite substantially in recent years and it is now standing at a 20 year high, well above previous years.”
“If you don’t anticipate that it will continue to increase then actually the likelihood is that dividends will grow more in line whereas the pace of recent years has been that dividends have grown much more quickly than earnings.”
The manager says investors should instead focus on low yielding stocks that look like there may be a chance of some small dividend growth.
Barnett, who has been at Invesco Perpetual for 20 years, now heads up three open-ended portfolios: the £12.4bn Invesco Perpetual High Income, the £6.3bn Invesco Perpetual Income and the £1.1bn Invesco Perpetual UK Strategic Income funds as well as four investment trusts: the £1.3bn Edinburgh IT, the £921m Perpetual Income and Growth IT, the £227m Keystone IT and the £63m Invesco Perpetual Select UK Equity IT.
He took the Edinburgh IT and Invesco Perpetual Income and Invesco Perpetual High Income funds due to the departure of Neil Woodford two years ago in the case of the former and since March 2014 in the case of the latter two portfolios.
According to FE Analytics, of his open-ended funds, Invesco Perpetual High Income has been the best performer over this period beating although both Invesco Perpetual Income and Invesco Perpetual UK Strategic Income have been top decile of the IA UK All Companies sector.
Performance of funds, sector and index under Barnett
Source: FE Analytics
However, an investor paying £10,000 into each of the three funds over the period Barnett has managed them would have seen the most income paid out of Invesco Perpetual UK Strategic Income over this period as the graph below shows.
Income pay out under pay-out under Barnett
Source: FE Analytics
In terms of cost, Invesco Perpetual Income is cheapest with a clean ongoing charges figure [OCF] of 0.91 per cent while Invesco Perpetual UK Strategic Income and Invesco Perpetual High Income are slightly more expensive at 0.92 per cent.
