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The income stream not being accounted for by the market

23 May 2017

FE Trustnet asks UK equity income managers how important special dividends are in the current market environment.

By Jonathan Jones,

Reporter, FE Trustnet

Investors need to recognise that special dividends can play an important part of their income stream, but not all income managers view them in the same way.

Special dividends have become an increasingly large part of the dividend landscape and have made up for a shrinking dividend roster in recent years.

Companies in the mining, financial and supermarket sectors – all formerly a large part of the roster – have had to cut or axe dividends in recent years as balance sheets have become more stressed.

Yet, some companies have started to come back on the dividend roster or grow previously cut pay-outs and some managers remain positive that this trend could continue to increase.

Indeed, even for oil majors such as BP and Shell, placed under pressure by low oil prices, there remains promise that the dividends are better covered than some may think: an area FE Trustnet will look at in more detail in a follow-up article.

However, given recent uncertainty in markets, special dividends have played a bigger role in the UK income space, accounting for £20bn of $90bn paid out in 2014.

Value of UK dividends since 2007

 

Source: Capita Dividend Monitor

While the amount paid out in special dividends has fallen in recent years – indeed they are down 90 per cent YoY in the first quarter according to Capita Dividend Monitor – they remain key for some managers given the concentrated nature of the market yield.

The top five income paying companies – Shell, AstraZeneca, BP, Vodafone and GlaxoSmithKline – account for some 56 per cent of all dividend payments in the UK.

This has often made it difficult for IA UK Equity Income funds to remain in the sector where, until earlier this year, funds had to deliver a target yield of 110 per cent of the FTSE All Share index, although it has now been lowered to 100 per cent.


Martin Cholwill, manager of the Royal London UK Equity Income fund, said he has managed to stay in the sector thanks to the benefit of special dividends.

“The concentration of dividend income in the UK market and the dominance of a handful of mega-cap stocks means that if you didn’t weight the average yield in the All Share index by size the average yield would be less than the current yield,” he said.

“The reason I have not had an issue with the mega-cap problem despite having lots of money in mid-cap is because of my process. I’m looking for cash generative-backed dividends and robust balance sheets.

“As such often the companies that I invest in have the embarrassment that they have cashflow left over.”

Income earned from fund over 5yrs

 

Source: FE Analytics *based on an initial investment of £10,000

Cholwill’s £1.8bn Royal London UK Equity Income is currently overweight UK mid-caps yet over the past five years has generated an income of £2,888.71 from an initial investment of £10,000.

“A number of companies I have invested in over the years have paid special dividends and that’s certainly what I have benefitted from in terms of meeting the dividend requirement so far,” he explained.

However, he added that while he has always met the income criteria, special dividends have played a big part in this.

“I think it really drops out of the investment process. There is an element that the estimated yield on the market never assumes special dividends,” he said.

“I’m not going to change the way I manage money and if the special dividends had stopped and the sector had kept with its 110 per cent yield I might have missed the target and kicked out of the sector.”


However, Cholwill (pictured) said that companies do not pay special dividends every year as illustrated by the 90 per cent YoY fall during the first quarter.

He said: “With special dividends clearly by definition they don’t come every year and they’re not necessarily predictable. Some years you get them and some years you don’t but it can be that one company pays one in one year and another pays it in another year.”

Another manager who uses special dividends is FE Alpha Manager Francis Brooke, manager of the Trojan Income fund. Brooke said they have become a more regular feature in the UK equity market in recent years.

“The Trojan Income fund has benefitted as the type of companies that we favour, often cash generators with a strong focus on capital discipline, have a higher than average propensity to make these additional distributions to shareholders.

“In recent years a wide range of companies such as Lancashire, Lloyds Banking Group, Compass and London Metric Property have paid special dividends.”

However, the veteran investor also never assumes that special dividends will be paid when making income projections for the fund.

Not all managers see special dividends as an important part of their investment process. Fidelity Moneybuilder Dividend manager Michael Clark said understanding the dividend stream – headline yields, dividend cover, dividend growth forecasts and dividend sustainability – is where he remains focused.

“When I assess candidates for my portfolios, I look beyond the headline yield and focus on the sustainability of the dividend and the company’s ability to grow earnings and dividends in the future,” he said.

“Ideally I’m looking for a ‘margin of safety’ by investing in easy-to-understand companies with consistent and predictable cashflows and solid balance sheets. And importantly I need to make sure I’m not overpaying for those qualities.”

Meanwhile, Jonathan Barber, manager of the Threadneedle UK Monthly Income said he was very conservative about recognising special dividends as income.

“They must demonstrably come from a company’s ongoing operational cashflow,” he explained.

“We would regard them as an incremental bonus from existing holdings and would not deviate from our well-established investment philosophy to specifically target them. Typically, we would expect to collect no more than a handful of them a year for any of our funds.”

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