UK dividend growth prospects are “not very good” in aggregate, according to star manager Neil Woodford (pictured below), who warned that many large-caps are overdistributing to investors.
In fact, he said companies such as Shell and BP – which currently yield 6.84 and 6.79 per cent respectively – should actually be cutting their dividends rather than aiming to grow them.
Performance of stocks over 10yrs
Source: FE Analytics
“There are lots of very large companies that are either sustaining dividends because they have big scrip alternatives or they’re distributing more than their free-cashflow, where there is very little prospect of dividend growth whatsoever,” the manager told FE Trustnet as part of our ‘Woodford Week’ series. 
“At an aggregate level – in the same way that on an aggregate level valuations aren’t attractive – it is hard to see how dividends in the UK can grow strongly.
“But, I’m not buying the market, I have bought a very specific subset of the market which I believe can deliver two things. First of all high levels of current income and, secondly, high levels of dividend growth.”
CF Woodford Income Focus launched in April this year after raising £553m, making it the third-biggest UK fund launch behind CF Woodford Equity Income and the Woodford Patient Capital Trust.
Woodford launched the fund due to increased client demand for a mandate which sacrificed some capital growth for higher levels of income.
Rather than set a yield target and aim to find stocks that matched it, the manager constructed an initial portfolio of stocks which were aligned with his core investment belief and that he had high long-term conviction in.
He found that each stock in the portfolio was on track to deliver at least 5 per cent yield in 2018 and demonstrated the ability to grow this distribution by 5p per unit in calendar 2018, which is where the fund’s initial target came from. From there, he expects the individual holdings to continue to grow their dividends by low to mid-single digits per calendar year. As its name suggests, the fund is also more concentrated than the CF Woodford Equity Income fund and has a portfolio of 53 holdings.
“The challenge was to go and build an equity income portfolio that I would be happy to present,” Woodford explained.
“It was a case of constructing an equity income portfolio that delivered what we say it can deliver – we didn’t specify a number – we simply went and built an equity income portfolio. Which I did, and the number that dropped out of that portfolio was actually some way ahead of 5p in 2018. That’s where the 5p came from.”
One notable feature of the fund is that, rather than residing in the IA UK Equity Income sector, it is a constituent of the IA Specialist sector.
Woodford made this decision based on giving his clients greater prospects of high and growing dividends so that, if there is ever a point in time when there are better opportunities overseas, he is not confined to holding a maximum 20 per cent weighting in non-UK investments.
“The objective of not having that limit was not that we could steal a march on other funds, it was all about making sure that in the future, we can have the flexibility to do something that we might deem at that time to be in investors’ interests,” the manager continued.
“The macroeconomic environment we are in and are likely to remain in is an environment in which traditional sources of income have been squeezed out of the scope of investors. Bond investors or cash investors and, even to some extent, retail property investors are finding income harder and harder to come by. It is just not available relative to what was available to investors during previous economic times.
“It’s a tough gig for investors. If they don’t want to get engaged in drawdown and they want to preserve their capital but equally get an income on their investment, there are very few areas that they can now access.
“My view for a long period of time has been that equity income is an area that has been out of favour and, frankly, ignored for too long.”
While it is indeed a difficult environment for investors, Woodford said he is able to find some particularly exciting equity income opportunities both within and beyond the UK when it comes to generating high and growing level of income.
An example of a holding that he is particularly excited about is Lloyds Bank, which he bought recently and that he also holds in his CF Woodford Equity Income fund alongside other additions. These were funded through inflows, a reduction in his British American Tobacco holding and a complete disposal of GlaxoSmithKline.
Performance of stock over 5yrs
Source: FE Analytics
“Lloyds is a business I have not owned for the best part of 15 years – it may be even longer,” Woodford said. “I didn’t own it coming into the financial crisis and I’d not owned it since the financial crisis until very recently.
“The bank has repaired its balance sheet, it’s generating an attractive surplus which we believe will be distributed to its shareholders instead of going to pay fines for PPI mis-selling. The ability of that company to return cash to its shareholders will grow strongly over the next few years. We think Lloyds in particular will deliver very strong dividend growth.”