The recent warnings over the UK dividend market are hugely overblown, according to F&C’s Gary Potter and Rob Burdett, who say that while dividends look challenged from an index perspective, the large majority of funds in the IA UK Equity Income space will be able to grow their income pay-outs. 
Numerous reports over the past six months or so have painted a particularly bleak outlook for UK dividends.
The principle reason for the bearishness is the concentrated nature of the UK income market, as the large majority of the total dividends paid out come from a very small pool of mega-cap stocks. On top of that, a number of those stocks are focused on natural resources – such as oil & gas and mining – which face significant challenges in the form of falls in the price of commodities.
Outside of those names, though, others have warned about the falling levels of dividend cover and earnings growth in the UK large-cap market while, at the same time, dividend pay-out ratios have increased significantly.
FTSE All Share’s dividend pay-out ratio
Source: Lazarus Partnership
As a result, many market commentators – such as Neptune’s George Boyd-Bowman – urge investors to turn away from UK equity income funds in the face of potential dividend cuts.
Potter and Burdett, who head up the F&C MM Navigator fund range, say investors need to take these warnings with a pinch of salt, however.
“We are hearing a lot of comments at the moment that the outlook for equity income and dividends is poor. Well, you are still getting a 3.5 per cent yield from the FTSE All Share – and some of that is vulnerable because of oil & gas and the miners,” Potter (pictured) said.
“But actually, you are getting a far better income from equities than you are out of bonds or cash. That’s an important point.”
Next, Potter says the recent reports by the likes of Capita and Canaccord Genuity shouldn’t necessarily be taken at face value.
The latest Capita UK Divided Monitor, for example, warned that UK dividend growth in 2016 is set to slow as big firms (mainly commodity-related businesses) will slash their pay-outs.
Research by Canaccord Genuity also warned that the UK market is facing an “epidemic” of earnings downgrades which will affect non-commodity companies as well given that dividend cover has fallen substantially over recent years.
Dividend cover in the FTSE 100
Source: Canaccord Genuity Quest
“Yes, energy (aka oils) and materials (largely mining) are down due to depressed commodity prices, but the trend in cash flow returns is also negative in healthcare, consumer staples (i.e. food products, beverages, tobacco and food retail), utilities and telecoms. That’s a big proportion of the market,” the report said.
Potter, though, says there is one point that many investors are missing.
“You will also probably see, when the Capita UK Dividend Monitor comes out about the outlook for income, there seems to a massive sense of negativity about dividends. Well, it’s worth remembering that around 40 per cent of all UK dividends are being declared in dollars.”
Relative performance of currencies over 6months
Source: FE Analytics
“Now, if companies like the oil majors maintain their dividends the fact that the dollar has become a lot stronger relative to sterling means there is a benefit to the income account by reporting it in dollars and transferring it into sterling.”
“It’s not all bad news on income. In fact, there might be some good news.”
Also, while Potter admits dividend pay-out ratios have increased, he isn’t overly concerned about this as the large majority of UK companies are financially sound while improving technology has meant company management teams now need to spend less on future investment. 
“I do agree that the dividend pay-out ratios have gone up, which obviously makes it harder to sustain. However, generally speaking, companies outside the ones which are challenged like oil, are in pretty rude health as their balance sheets are pretty strong.”
That being said, Burdett (pictured) says investors should prepare for some bad news surrounding the UK dividend-paying market this year.
“In the UK market, you will see those headlines [about dividends] saying your fears have been realised because some 70 per cent of UK dividends come from the top six or seven companies and a number of those are challenged,” Burdett said.
“Those will be challenged either by the pay-out ratio or issues surrounding their resource prices and it doesn’t look like the banks are going to replace them which some had hoped for. So, UK headline dividends are definitely challenged and that will affect index trackers, though there are very few passive equity income vehicles and that is probably just as well.”
However, by using active funds that don’t follow the benchmark, investors can alleviate this problem.
At the moment, Potter and Burdett use the PFS Chelverton UK Equity Income, Majedie UK Income, Ardevora UK Income, Standard Life Investments UK Equity Income Unconstrained and JOHCM UK Equity Income funds for their exposure and all of them have significant exposure to the FTSE 250 where underlying dividend cover, a precursor to dividend growth, is strong.
“If you look at the pay-out ratios on UK small cap funds like Chelverton UK Equity Income, they are tiny at about 15 per cent but the dividends are growing at 15 to 20 per cent. Plus, they are unchallenged by global macro factors.”
The five crown-rated PFS Chelverton UK Equity Income fund, which is managed by David Horner and David Taylor, is almost entirely invested outside of the FTSE 100 and is currently throwing off a 4.55 per cent yield.
Not only has the £450m fund been a top quartile performer in the IA UK Equity Income sector since its launch in December 2006 with total returns of 80.32 per cent, it has been the highest dividend-paying fund in the peer group (aside from those which use covered call options) over that time.
FE data shows that investors who bought £10,000 of the fund at launch would have since earned £4,330.94 in dividends.
PFS Chelverton UK Equity Income’s dividend history
Source: FE Analytics *figures based on £10,000 investment in January 2007
As the graph above shows, while its pay-outs haven’t increased year on year, Horner and Taylor have gradually increased their dividend over that time.
However, Burdett isn’t just positive on the Chelverton fund.
He added: “All of equity income funds in the UK are predicting 5 to 10 per cent growth in their underlying dividends this year.”
Potter and Burdett’s F&C MM Navigator range is one of the most popular destinations for fund of fund investors.
Their largest, and one of the most successful, has been the £1.1bn F&C MM Navigator Distribution fund – which carries five FE Crowns. FE data shows it has comfortably outperformed its IA Mixed Investment 20%-60% Shares sector average since launch in October 2007 with returns of 40.63 per cent.
A recent FE article also showed that it has been the highest dividend-paying multi asset fund in the Investment Association over the last five years.
