The dividend outlook for the UK dividend market is looking particular mixed, according to Evenlode’s Hugh Yarrow and Ben Peters, who urge investors to back the diminishing number of high quality businesses that can grow their income pay-outs over time. 
Concerns have been on the rise towards the future of dividend pay-outs in the UK stock market, with many industry commentators expecting more businesses to join the already large number of companies that have had to slash their distributions over the past year or so due to poor earnings growth and falling levels of dividend cover.
The second ‘Evenlode Sustainable Dividend Report’, which is authored by Hugh Yarrow (picutered) and Ben Peters who run the five crown-rated Evenlode Income fund, paints an equally poor picture for FTSE-listed stocks as a whole.
“The dividend outlook for the overall UK market is very mixed. Several large UK companies have announced, reduced or cancelled dividends over the last year or so,” the report said.
“These cuts have been focused on the energy, mining, food retail, banking and utilities sectors. A variety of factors have led to these cuts: industry difficulties, large capital investment requirements, poor cash generation and high debt levels. The recent UK referendum result may also affect the UK market’s future dividend payments.”
“UK domestic sectors such as banks, commercial property, construction, house builders and retailers may find it more difficult to sustain or grow dividends.”
Therefore the managers – whose fund has doubled the returns of the FTSE All Share, has grown its dividend in every year and paid out more in total dividends than its average peer since launch – have used the report to the highlight the 10 UK stocks they believe have the strongest dividend potentials.
Evenlode Income’s dividend history
Source: FE Analytics
To do it, they analysed each UK stock’s dividend sustainability and dividend growth potential using its free cash flow.
To make the final cut, each of the companies featured in the report have strong cash flow return on invested capital, low or no debt, strong free cash flow cover, a long-term track record of growing dividends, a market cap of £500m, at least two years of dividend cover and a current dividend yield of more than 2 per cent.
Here we highlight the five of the 10 stocks to make the grade and the UK equity income funds that hold them.
Sage Group
First up is FTSE 100-listed technology company Sage Group, which currently has a dividend yield of 2.5 per cent and has a five year average dividend growth rate of 10 per cent.
The company – which is a global market leader in the provision of enterprise software for small and medium-sized businesses – is Yarrow and Peters’ fourth largest holding in their fund.
“[Sage’s] products, such as accountancy software, become embedded in the day-to-day running of a business, creating a consistent revenue stream from subscription and support contracts. This revenue is growing steadily and now makes up almost three-quarters of sales,” they said.
“The company routinely converts profit to cash flow, the balance sheet is strong. Sage has grown its dividend every year for the last 15 years.”
As a beneficiary of weaker sterling, shares in Sage have rallied strongly of late and have returned a hefty 20.19 per cent already in 2016.
Performance of stock versus index in 2016
Source: FE Analytics
It is a popular holding among UK fund managers. According to FE data, seven IA UK Equity Income funds count Sage as a top 10 holding including the likes of Standard Life Investments UK Equity Income Unconstrained, Newton UK Income and Schroder UK Alpha Income.
The likes of CF Lindsell Train UK Equity in the IA UK All Companies sector also have large bets on the stock.
Fidessa
Only one fund in the peer group counts Fidessa – which provides mission critical software to the financial services industry – as a top 10 holding (MI Chelverton UK Equity Income) due to poor share price performance over the past 12 months.
However, the Evenlode duo says that while earnings growth has been muted, the FTSE 250 stock is a very attractive dividend prospect going forward.
“Fidessa’s markets have been difficult over the last two years as its customer base has faced headwinds, slowed spending, and in some cases merged with each other,” the report stated.
“Meanwhile, Fidessa is making a very significant investment in its new derivatives offering. We estimate that current earnings would be approximately 40 per cent higher if Fidessa stopped this investment and just focused on its existing equity platform, but we’d rather they continue to burden current financial results with this project – the long-term potential for the product is excellent.”
“Fidessa deliberately operate a very prudent balance sheet with no debt and a strong net cash position. Because the company is capital-light, it needs little of its cash flow each year, so free cash flow is regularly returned as ordinary and special dividends.”
“Including its regular annual special dividend, the stock’s current dividend yield is 3.7 per cent.”
PayPoint
This is another capital-light technology that has also had a painful 12 months in share price terms, but a current dividend yield of 4.9 per cent and a dividend growth rate of 13 per cent over the past five years, Yarrow and Peters say it is a welcomed addition to the list.
Performance of stock versus index over 1yr
Source: FE Analytics
Evenlode Income currently has 2.2 per cent in PayPoint, which is a payment technology company, helping consumers pay utility bills, top up mobile bills, pay tax, buy parking tickets and send parcels.
“The business has limited capital requirements and its strong free cash flow and net cash balance sheet supports a healthy dividend yield.”
“Management takes a pragmatic attitude to returning excess cash to shareholders and along with growth in ordinary dividends, they recently announced a programme of special dividend payments over the next five years to return surplus cash that has built up on the balance sheet.”
Like Fidessa, PayPoint isn’t a widely held stock. Indeed, the only IA UK Equity Income fund to count it in its top 10 is VT Odd Real Income, though FE Alpha Manager Mark Martin is also a fan: he has big positions in the stock in both his Neptune UK Mid Cap and Neptune UK Opportunities funds.
Page Group
Next up is global recruiting firm Page Group which, interestingly, doesn’t feature in any IA UK Equity Income or IA UK All Companies fund’s list of top 10 holdings.
Yarrow and Peters suggest this is due to the fact that it is seen as a more cyclical company – its shares have fallen a hefty 34.68 per cent already this year but have rallied by 27 per cent since the Brexit vote.
Nevertheless, with a dividend yield of 4.3 per cent and five year dividend growth of 5 per cent, the duo think it is only a matter of time before more income investors become interested in the stock.
“Page has good medium to long-term growth potential thanks to structural growth in the outsourced recruitment market, particularly in developing countries,” the report said.
“It is an economically sensitive business, but as an asset-light business with a low capital intensity, cash generation is strong through thick and thin. Management also look to run the business very conservatively over the industry cycle.”
“The company never borrows money, and its growth over the years has been driven by organic expansion rather than by acquisition. This consistent approach has enabled Page to take market share in more difficult times, while continuing to pay healthy dividends too.”
Compass
The final stock in this part of the series is Compass Group, a global player in the food service industry which provides outsourced catering solutions to businesses and institutions.
Evenlode Income has 3.3 per cent in the FTSE 100 stock and it is also a top 10 holding in five IA UK Equity Income funds: three of which are Trojan Income, Kames UK Equity Income and Insight Equity Income Booster, although Franklin UK Rising Dividends (which sits in the IA UK All Companies sector) also counts it in its top 10.
It isn’t too surprising it is a more popular holding than others in this article, especially as Compass’ share price has risen by 43 per cent in total return terms over 12 months and received a boost from Brexit-induced sterling weakness.
Performance of stock versus index over 1yr
Source: FE Analytics
“[Compass’] growth opportunities are good thanks to steady structural growth in food outsourcing and the company’s global expansion strategy.”
“Compass has a resilient business model backed by long-term contracts with high renewal rates. It also has a low capital intensity, and consistently convert profits to free cash flow. Dividends have grown every year since 2001, when Compass demerged from Granada Group, with growth over the last five years averaging +10 per cent per annum.”
