Equity income investors in the UK have seemingly never faced a more difficult decision thanks to recent market trends. 
On the one hand, they could choose the higher yielding members of the index – but due to falling levels of dividend cover because of poor earnings growth, there is the chance that the level of income they will receive could well be reduced.
On the other hand, they could go for the higher quality lower yielding stocks that should maintain their dividends over time – however, the issue being that their perceived ‘safe’ characteristics means investors may well be taking significant valuation risk by buying those sorts of stocks now after they have performed so well.
However, Thomas Moore – manager of the popular Standard Life Investments UK Equity Income Unconstrained fund – says there is a third option that investors may wish to consider.
Standard Life Inv UK Equity Income Unconstrained’s dividend history under Moore
Source: FE Analytics
Not only has the £1.2bn fund significantly outperformed from a total return point of view since Moore took charge in January 2009, but the fund has grown its dividend in each calendar year and paid out more in total income than its average peer in the IA UK Equity Income sector over that time.
Moore (pictured) is also confident that he can maintain his 12 per cent dividend growth over the medium term, thanks to his investment philosophy which centres on undervalued companies that have the potential to grow their dividends rather than focusing on a high starting yield.
In this article, he looks at the types of stocks he invests in compared to typical high yielding companies and those that are perceived safe by many via a number of different metrics.
To highlight his approach, he has combined three of his favourite companies in his fund – BT, National Express and Saga – which he has called ‘sustainable income’ names.
For high yielding mega caps (which make up a large proportion of the index), he has used Royal Dutch Shell, GlaxoSmithKline and HSBC and as an example of higher quality companies which are often dubbed ‘bond proxies’, he has used Unilever, Diageo and British American Tobacco due to the apparent reliability of their earnings.
Here, Moore highlights how those three baskets of stocks compare in terms of dividend yield, dividend cover, dividend growth and their P/E ratios.
Dividend yield
“You can see that, of these three baskets of stocks, the mega-caps look the best on dividend yield at 6.2 per cent – it’s a huge yield,” Moore said. “Second is sustainable income at 3.9 per cent and thirdly bond proxies averaging 3.2 per cent.”
Stocks’ dividend yield
Source: Standard Life Investments
He argues that all three look attractive from that point of view, especially in the context of interest rates at 0.25 per cent and bond yields (both in terms of corporate and government debt) near their record lows.
“None of those three are unattractive. You can see the attraction of the equity market is that there are yields like these available.”
Dividend cover
However, Moore says the differences and potential problems for the three baskets of stocks start to appear when you look outside of divided yield. Firstly, he says some of those yields don’t look as attractive when underlying dividend cover is taken into account.
“There is a huge divergence here in the sustainability of these different baskets of stocks,” Moore said.
“If we start with the least sustainable, mega-caps have 1.1 times dividend cover. It is tight, I have been warning for some time that the UK equity market dividend pay-out was looking shaky and that sort of dividend cover shows there isn’t much room for comfort.”
Stocks’ dividend cover
Source: Standard Life Investments
He notes that there is going to have be some sort of improvement in company fundamentals for those businesses to pay that 6.2 per cent yield or else they are likely to be joining the growing list of UK stocks that have had to cut their dividends over the past 18 months or so.
While some may think this is a good excuse to buy the bond proxies, he says those stocks also face potential issues.
“Bond proxies are OK at 1.6 times, but it’s not desperately comfortable in the context of history. Dividend cover has tended to run are much more comfortable levels in the past so, again, it does rely upon growth coming through.”
On the other hand, he says the sustainable income basket’s 1.9 times dividend cover is very attractive and a good precursor for future dividend growth.
Dividend growth
“If you’ve got companies producing the earnings and the cash flows that can sustain dividend growth, then you are in a good place,” Moore said.
It is for this reason that Moore, unlike many of his peers in the sector, is avoiding some of the largest members of the FTSE 100.
Stocks’ dividend growth
Source: Standard Life Investments
“The mega-caps’ average dividend growth of 0 per cent. There are some analysts that are expecting dividend cuts among these three companies. Either way, 0 per cent dividend growth means you are in a situation that is not too dissimilar to a high coupon, low credit rating corporate bond.”
“If they carry on paying that coupon, great, but the risks are there and I think it is worth flagging that up. Yes, you may receive a dividend yield of 6.2 per cent, you’ve got to be aware that the dividend cover of 1.1 times and dividend growth of 0 per cent means you are exposed to risks.”
He notes that bond proxies do, however, offer good dividend growth of 4 per cent though his sustainable income stocks offer dividend growth of 12 per cent (which is the same dividend growth for his portfolio overall).
“There is a lot to be said for bond proxies in this environment, especially if you are an asset allocator.”
However, he says there are other reasons why he prefers the sustainable income basket of stocks – one of which is to do with valuations on offer.
P/E ratios
“Interestingly, the P/E on mega-caps is rather high on 15 times. It is a little bit below the market average at 17 times – which is pretty punchy,” Moore said.
“I would say 15 times is pricy but bond proxies are off the scale at 20.1 times. I know it is in vogue to be buying them, but the stats tell you that if you pay a high P/E for a stock, you are likely to receive a lower than average return.”
Stocks’ P/E ratios
Source: Standard Life Investments
“We love the consistency of bond proxies, but we don’t want to be paying 20 times for that because if history is any guide, paying that sort of valuation is a recipe for disappointment.”
There have been a number of market commentators who agree with Moore on this point, such as Premier’s Simon Evan-Cook who told FE Trustnet last year that the funds which have benefitted from bond proxies’ significant outperformance (examples being CF Lindsell Train UK Equity and Fundsmith Equity) may well be in for a tougher period due to the current valuations on offer.
“There is a risk that, having done so well, that – to use Nick Train’s terminology – these type of funds go to sleep for a while,” Evan-Cook said.
Moore adds, though, that the sustainable income basket is the lowest rated of the three at 13.6 times (which is possibly due to the fact that they are more UK centric than the other baskets and have therefore been caught up in the recent Brexit uncertainty).
“We are saying that you don’t have to settle for expensive bond proxies and you don’t have to gamble on dividend sustainability of those mega-caps.”
