Dividend growth across the FTSE All Share will continue to slow over the medium term, according to Hugh Yarrow, who warns that even high quality, cash generative companies are facing a major challenge. 
The subject of UK dividends has been a major talking point within the industry of late, especially given the sheer demand for income but significant falls in bond yields over the past 10 years or so.
Thanks to this demand for yield, UK companies have been increasing their pay-out ratios over recent years to entice shareholders. However, due to slowing earnings growth linked to a still poor economic backdrop, levels of dividend cover – particularly across FTSE 100 companies – have fallen substantially.
As such, various industry experts had been warning that dividend cuts would be far more widespread over the coming year – adding to the high profile names that have already had to reduce their pay-outs like Sainsbury’s, Centrica, Rolls Royce and Anglo-American.
Those fears seem to have dissipated somewhat, though, with the surprise EU referendum result causing the pound to plummet in value, which in turn is expected to add some £3.4bn to UK dividend payments due to the fact that some 20 per cent of all UK dividends are paid in foreign currencies.
Performance of sterling in 2016
Source: FE Analytics
Though some see this as a ‘dividend bonanza’, the Capita UK Dividend Monitor also highlighted the potential negative impacts Brexit will have on business confidence and foreign investment which will likely hurt dividend payments further down the line.
Yarrow, who manages the five crown-rated Evenlode Income fund, also warns that the referendum means UK equity income investors face a very challenging backdrop.
“Overall, the dividend outlook is very mixed,” Yarrow (pictured) said.
“Clearly, you have had some quite high profile cuts in the UK market over the past year or two which have been focused on the energy and commodity producers and also sectors like food retailers and – to an extent – banks and utilities.”
“Those dividend cuts are now washing through the market and will have an overall impact on the yield available.”
“Clearly, the referendum result will probably mean the outlook for dividends in the likes of the banking sector, housebuilders and commercial property are less good than before – that’s not necessarily to say there will be lots of cuts but there might be some and growth rates may be lower than first expected.”
In truth, most have warned about the dividend outlook for more cyclically orientated businesses like mining, oil and certain financial stocks for some time now. However, Yarrow warns that even the ‘expensive defensive’ (or ‘bond proxy’ stocks) which have been an income investors best friend over recent years now face significant challenge as well.
“However, I think there is a more general trend that we have been talking about for a long time which is that dividend growth has slowed and it’s a result of the overall economic environment.”
“Even if you are a resilient cash generative business, with the deflationary pressures in the world, demand growth is lower and it’s just more difficult to generate top-line growth. We’ve seen it even in the cash generative, asset light businesses we focus on, there has been a slowdown in dividend growth.”
“The average dividend increase in the portfolio most recently was about 5 per cent and that compares to a 15-year average growth rate of about 9 to 10 per cent.”
This is also partially borne out in FE data. According to FE Analytics, for example, the average increase in dividend pay-out in the IA UK Equity Income sector slowed from 9 per cent in 2014 to just 3.9 per cent in 2015.
Average distribution on £10,000 in the IA UK Equity Income sector
Source: FE Analytics
The issues surrounding potential dividend payments have been highlighted in the IA UK Equity Income sector.
Under the current rules (as the Investment Association has launched a consultation into its guidelines), funds must yield 110 per cent of the FTSE All Share over rolling three-year periods to qualify for the sector.
This criteria has worked well for a number of years, but recent market dynamics have caused many funds – including Yarrow’s – to be booted across to the IA UK All Companies sector.
That is because as some of the index’s largest constituents face challenged dividends (which, along with macro concerns, have caused their share prices to drop), the yield of index has risen strongly.
While there is obviously a grey area, managers seemingly face the option of buying high quality companies that will pay their dividend (but risk being kicked out of the sector) or buying high yielding companies than may not pay their dividend (and risk putting their investors’ money in danger).
Yarrow, who has increased his £655m fund’s dividend in each year since its launch in 2009 and is on track to raise it once again in 2016, has kept to his usual investment process of backing high quality, cash generative businesses with asset-light business models (such as Unilever and Diageo), and his portfolio is now therefore in the IA UK All Companies peer group.
Evenlode Income’s dividend history
Source: FE Analytics
“The dividend yield on the fund is about 3.6 per cent (10 basis points lower than the FTSE All Share), which we think is quite attractive. The yield has certainly been lower than that,” Yarrow said.
“However, the reason we have moved sector is because we are being compared to the FTSE All Share’s yield which is being artificially inflated by historic payments from big mining companies which have now been cut or cancelled. However, because the index’s yield is backward looking they are still included.”
“That will be flushed out over time and we expect, over the medium term, to return to the income sector.”
Many do indeed find it odd that Evenlode Income fund is no longer in the sector given it has never cut its dividend, paid out more than its average peer in total dividends over five years and been one of the best in its old peer group for protecting capital.
Its unit price performance has been the major reason why it is no longer in the sector, though, has been a top decile performer in both UK sectors and nearly doubled the returns of the FTSE All Share since its launch.
Performance of fund versus sectors and index since launch
Source: FE Analytics
It is also top decile over one, three and five years and beaten the FTSE All Share in every calendar year since inception.
While many will be put off buying Evenlode Income given its lower than average yield, Yarrow points out that his current 3.6 per cent isn’t that low compared to the fund’s history. Indeed, over that past 23 quarters, Evenlode Income’s average yield has been 3.7 per cent.
Yarrow added: “The thing that has changed is that other sectors of the market that we don’t invest in have had poor capital performance and are therefore trading on very high historic dividend yields.”
The graph below shows the fund’s published yield compared to the average yield in the IA UK Equity Income sector running back to 2011.
Fund and sector’s yield since 2011
Source: FE Analytics
It shows that the fund has consistently had a lower yield than the sector average (except for two out of a possible 23 quarters), but the real relative fall in yield has come over the past 12 months – a period where the FTSE All Share has made 2 per cent, the average IA UK Equity Income fund has lost 0.8 per cent and Evenlode Income has made 14 per cent and therefore topped the peer group.
In an upcoming series of articles, FE Trustnet will take a closer look at the UK equity income funds that have consistently yielded more or less than the market and analyse whether those figures bear any relation to actual income pay-outs over time.
