How safe are UK dividends right now?

There is very little threat to UK dividends generally despite fears that companies are stretching themselves too much through hefty pay-outs, according to Michael Clark.

The manager, who runs the five crown-rated Fidelity Moneybuilder Dividend fund, says that there are a number of attractive sectors within the UK market that look set to keep paying generous dividends amid the current market-wide hunt for income.

Richard Colwell, who manages the five crown-rated Threadneedle UK Equity Income fund, holds more FTSE 100 stocks than his sector average and points out that many constituents of the blue-chip index are indeed resilient to economic headwinds.

With gilt yields and UK credit yields at a historic low, an increasing number of investors have turned to the UK equity income space in the hunt for regular pay-outs.

Performance of sectors in 2016

Source: FE Analytics

However, with 14 UK companies slashing their dividends over the past 18 months or so, many investors are concerned that some of the higher yields being offered by blue-chips are unsustainable over the medium term.

This then begs the question as to whether to opt for low dividend-paying and more expensive and safer stocks, or to go for companies offering the higher yields but require a greater risk tolerance from investors.

This predicament has also presented itself within the IA UK Equity Income sector, with a number of fund managers being removed from the space for steering clear of the higher-risk, higher-yielding stocks and therefore failing to meet the Investment Association’s yield requirements.

Clark, who has managed Fidelity Moneybuilder Dividend since 2008, says that there are rightfully concerns over a small number of individual blue-chips and their ability to continue paying their current dividend yields, but says that generally there are no significant threats to dividends in the FTSE 100.

“By and large, if you look at the market excluding mining and oil, the dividend pay-out ratio - which is the dividend per share divided by the earnings per share - is within historic tolerances,” he said at the recent FE Trustnet Select UK Equity Income Event,

“In fact, it’s below that ratio and below the very long-term average from the mid-80s. It’s nowhere near the very stretched number we saw in the early 90s at the time of the recession there.”

The manager says the reason for this is the level of panic that was generated by the financial crisis in 2008, which pushed a large number of companies to focus on reducing debt, managing their capital spending and withdrawing from high-risk acquisitions.

Because of this greater focus on cash generation, he says that dividends are well-supported despite the fact we are in a slow-growth environment.

“I’m assuming that there is no threat to general dividends and I’m also assuming that the very low interest rate environment and very low growth environment will continue into the medium term,” Clark continued.

“We won’t get a situation where we go back to the level of gilt yields and corporate credit yields that we saw 10 or 15 years ago.”

“It may come up a little bit – it’s hard to see them going down very much from here – but I’m assuming we stay in this environment of slow growth and low returns for the medium term and, within that, I think it’s important to be selective in terms of sectors.”

The manager says that the most attractive sectors for income at the moment are pharmaceuticals, consumer goods, regulated utilities and some telecoms.

Colwell, who also presented at the event, agrees that there are certain sectors within the UK blue-chip index that are more resilient to macroeconomic headwinds than others. According to his research, these defensive areas of the market also dominate the FTSE 100 index and account for a 42 per cent total weighting.

At the same time, he says the higher-risk commodities constitute half the weight of the FTSE 100 than they did just five years ago.

“We didn’t go into Brexit with a load of hot money in UK equities – far from it – actually international investors were at an 80-year low exposure to UK equities. There were very fearful of UK equities because of the pre-occupation with our exposure to commodities and before that there was a lot of recycling of money into Europe and Japan following the QE trend,” the manager explained.

“That’s why I think it’s quite interesting that now we’ve had a currency adjustment, surely as an international investor UK equities look pretty attractive.”

“Also, 40 per cent of the FTSE’s exposure is to the foods, tobacco and pharmaceutical sectors which are pretty resilient to the economy and are obviously dollar earners. I think that’s why you’ve seen the move up in the markets.”

Colwell says that the fact 70 per cent of the FTSE 100’s exposure is outside the UK, combined with the 15 per cent drop in sterling, has led to 11 per cent upside on the index’s earnings per share on FX translation.

He also says that negative sentiment on the UK market and the fact that it is the most underweight region among global allocators has positioned the FTSE 100 at cycle lows and is likely to become more attractive to international investors over the shorter term.

“[This time last year] all the active funds were mid and small-cap skewed, they were chasing returns and maybe hadn’t appreciated the risk that a lot of those stocks were on cyclically high earnings so that’s accentuated the move [from small to large-caps].”

“From my perspective on the fund, this time last year I might have seemed a bit dull because I wasn’t interested in domestics or banks. I was more interested in buying international earners like GlaxoSmithKline and AstraZeneca, where there was certainly not peak profitability,” the manager continued.”

Performance of indices in 2015

Source: FE Analytics

“I wasn’t clever enough or bold enough to shape the portfolio for a particular referendum outcome but I just knew the market had come a long way from the lows of 2009 and we were due some sort of flux.”

“That’s why going into Brexit we were over-exposed to dollar earners and held no banks. Yes we have some domestically-orientated stocks which did get hit, therefore we’ve had an opportunity to buy more, but it was less than 30 per cent and not more than 50 per cent like some other funds.”

Colwell says that the overwhelming outperformance of small and mid-caps over recent years led to a historically high number of active managers outperforming the FTSE All Share, placing the index in the bottom decile against all actively-managed growth and income funds.

However, he warns that this pattern tends to rear its head before recessions and did so both in 2007 before the financial crisis and in 1999 during the build-up to the TNT bubble.

“At the end of cycles you get big momentum trading and everybody craving those last bits of return while overlooking the risks,” he continued.

“Now where we are, what I’ve said to the team is ‘for goodness sake don’t do the comfort trade into the teeth of Brexit’. There was a lot of emotion flying around and everyone looking at the screen but the worst thing you can do is go out and buy a lot more dollar-earners for risk adjustment reasons.”

“The worst thing you can do is go and puke those housebuilders that you were loving only two months ago. You have to sit on your hands, get a clear head and do the analysis.”

That said, the manager is pleased with the dollar earners he already has in his portfolio and will continue to hold them, despite the fact he isn’t looking to increase his allocation to the market area any time soon.

At the margin, he says it could be prudent to slightly trim some of these holdings to make room for domestic-orientated stocks that have suffered from significant pull-backs such as ITV, L&G and BT.

“We haven’t effected a big change in the tilt to the portfolio because in a way we think it’s too early – we’ve had this rally post-QE but I wouldn’t declare victory on markets or anything like that,” Colwell continued.