Investors should expect widespread dividend cuts in the UK market, according to Neil Woodford, who says sectors such as mining, oil, industrials and banks are going to be the biggest sources of disappointment. 
Concerns over the outlook for the UK dividend market have risen markedly of late at a time when the demand for income, thanks to ultra-low interest rates, high valuations in the bond market and an ageing population, has only increased.
On the face of it, the FTSE All Share’s dividend yield of 3.85 per cent as of the end of January looks attractive relative to other asset classes such as bonds.
However, the index’s yield has spiked as most market participants believe many of its largest constituents will have to reduce their pay-outs due to issues such as falling commodity prices, low levels of dividend cover, high pay-out ratios and poor earnings growth.
FTSE 100’s dividend cover
Source: Canaccord Genuity Quest
Woodford, who launched his now £7.7bn CF Woodford Equity Income fund in June 2014 following 26 years at Invesco Perpetual, says investors need to make sure they don’t chase yield in the current environment as they are only likely to be disappointed – both from an income and total return perspective.
“The market’s yield is being distorted by the appearance of dividend yield where I think it will not be paid,” Woodford (pictured) said.
“For example, in the resources sector there are any number of FTSE 100 companies in the mining space that look like they have low double-digit/high single-digit yields. They clearly haven’t, many of them won’t be paying any dividends let alone cutting significantly.”
“The market yield has been distorted by the fact that prices have fallen and dividends have not yet been cut, but they will and that is the next chapter in this rather difficult market environment.”
In truth, the large majority of comments surrounding potential dividend cuts have been directed towards the mining sector.
Following China’s slowdown and a significant plunge in underlying commodity prices, most miners have been put under severe market stress. This has led some companies to already to cut their pay-outs (such as Anglo-American which now yields 23 per cent) while others are very much expected to, such as BHP Billiton with its current yield of more than 13 per cent.
Performance of indices over 3yrs
Source: FE Analytics
However, others – such as analysts at Canaccord Genuity – warn the risk of cuts doesn’t end there as they believe the UK market is facing an epidemic of earnings downgrades.
Woodford agrees that there are many other areas of the market which pose significant dividend risk.
“I think you will see dividend cuts coming in the oil sector. I think you will see dividend cuts across the industrial sector and indeed in financials,” Woodford said.
“The market’s views on the likes of Lloyds, Barclays and RBS was that they would be generating surplus capital and would be distributing that to shareholders. I think that is not going to happen, so I think there will be dividend disappointments in the banking sector too.”
He added: “There are a number of areas to worry about.”
Woodford, therefore, is avoiding large parts of the index in his CF Woodford Equity Income fund despite the high yields on offer.
“We are deliberately not exposed to those areas,” he said.
“We think the tobacco sector will be growing dividends. Imperial Tobacco, which is our largest holding, has an explicit commitment to deliver 10 per cent dividend growth and I think it’s more than capable of achieving that.”
“We think we will get good dividend growth from BAT and Reynolds.”
There have, though, been some concerns surrounding one of Woodford’s largest holdings – GlaxoSmithKline.
The stock currently makes up 6.32 per cent of his portfolio and has a yield of 5.91 per cent. As a result, it currently accounts for close to 10 per cent of his fund’s current 3.6 per cent yield, according to FE data.
In an article last year, Franklin Templeton’s Colin Morton warned that the company had a challenged dividend given falling levels of cover.
“At the moment, however, the current dividend level is not covered as much as I would like. If the business doesn’t improve or if things significantly worsen for them over the next year or two that is something I would say is definitely a risk,” Morton said.
He added: “It’s certainly not a dividend you can sit and feel comfortable about.”
To add fuel to the fire, Woodford’s successor at Invesco Perpetual Mark Barnett has since completely exited a longstanding position within the company in his UK equity income funds.
However, Woodford says investors need not worry.
“In the pharma sector, Glaxo won’t be growing its dividend. It will be paying a special this year, but won’t be growing its dividend and neither will AstraZeneca. However, we should see good dividend growth in other parts of the portfolio in the healthcare space.”
Since Woodford launched his new fund, it has been the best performing portfolio in the IA UK Equity Income sector with returns of 12.32 per cent. As a point of comparison, the FTSE All Share has lost 11 per cent over that time.
Performance of fund versus sector and index since launch
Source: FE Analytics
Investors who bought £10,000 worth of units in the fund would have since earned £432.99 in dividends.
