Historically low relative valuations, growing inflationary pressures and a stronger-than-expected dividend recovery make the IT UK Equity Income sector a promising bet for investors, according to Investec analysts Alan Brierley and Ben Newell.
The sector has had a torrid time over the past few years. UK dividends fell by 43% to £64.3bn in 2020 during the pandemic as companies conserved cash to protect against the economic slump caused by numerous lockdowns.
Earnings per share (EPS) were heavily affected as a result, with Edinburgh Investment Trust, Lowland and Temple Bar suffering. Their EPS fell by 41.8%, 50.3% and 76.4% respectively, although others such as Dunedin Income Growth and Murray Income – down 9.8% and 12.6% respectively – held up better.
Source: Investec
Despite the most challenging of backdrops, 12 out of 16 companies featured in the latest Investec report increased their dividends, while one – Finsbury Growth & Income – held it.
“This experience contrasts starkly with that of the UK equity income open-ended sector, where the average dividend cut last year was 29%,” Brierley said.
Much of this was due to revenue reserves – excess income that has been retained as a backup in the event of a market shock.
“Not surprisingly given the initial onslaught last year, there has been a fall in revenue reserves,” added Brierley, as the below chart shows.
Source: Investec
However, with a strong recovery in UK dividends now underway, the majority of investment companies still have reasonable levels of revenue reserves for future shocks, he added.
There has been a significant recovery in payouts this year. Last month Link Group said UK dividends in the first three quarters stood at £79.9bn, 50% higher than the previous year, with a particularly strong third quarter.
Dividends from UK companies remain below their pre-pandemic levels however, with the Link Dividend Monitor forecasting a return to 2019 payouts by 2024.
“A strong recovery in UK dividends this year has been a welcome development,” Brierley said. “With UK equities approaching pariah status, and investors focused on stocks with higher growth characteristics, storm clouds have gathered over the UK equity income sector in recent years.
“However, we are mindful that relative equity valuations have now reached historically depressed levels, which is no doubt a catalyst for the ongoing surge in M&A activity. While actions by central banks have again generated significant returns for investors, we see greater challenges, most notably growing inflationary pressures.”
Against this backdrop, he said that UK equity income trusts had “an important role to play” within a diversified income portfolio.