Managers need to back their convictions and not follow the crowd, according to Royal London UK Equity Income fund manager Martin Cholwill, who said there are a number of widely held stocks he is avoiding.
The UK dividend roster has shrunk in recent years as a number of companies either scrapped or cut their dividends, although there have been some positive signs as dividends increased by 9.5 per cent YoY in the first quarter, according to Capita Dividend Monitor.
However, the pool of income stocks remains concentrated with the top five yielding companies – Shell, AstraZeneca, BP, Vodafone and GlaxoSmithKline – paying 57 per cent of all UK dividends.
Indeed, the top 15 dividend-paying companies equate for some 81 per cent of all UK dividends making it difficult for income managers to differentiate themselves.
However, Cholwill (pictured) said it is possible for fund managers to set themselves apart as long as they are prepared to back their conviction and “not just go with the crowd”.
The manager has a more mid-cap focus in the four crown-rated, £1.8bn Royal London Equity Income fund, than some of his peers.
The fund has a historic yield of 3.88 per cent despite not holding some of the top income-paying stocks in his portfolio of 52 holdings.
“There have plenty of examples of large companies that have cut their dividends over the last couple of years so there is nothing inherently safer in my view in large-cap company dividends than there are in mid-cap company dividends,” the manager said.
“Size isn’t the issue, it is the financial structure and cashflow characteristics which are key and I think sometimes people are looking at it from the wrong starting point.
“I’m happy to be different. As a fund manager it is about getting it right and by and large I have avoided the large majority of the dividend cuts and that has been one of the things that has helped performance.”
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
Indeed, performance has been strong, with the fund in the top quartile of the IA UK Equity Income sector over one, three and five years.
“Some of the stuff I am quite cautious of at the moment are quite widely-held within income funds,” Cholwill said.
“Obviously in the concentrated portfolio that I run, it is what I own that drives performance rather than what I avoid. But equally I do have some clear views of popular stock names held in income funds that I am relatively cautious of.”
The first stock avoided by Cholwill is Vodafone: one of the top five income payers in the UK. The company paid out a total dividend of 14.77 eurocents per share last year – up 2 per cent on the previous year.
“If you look at Vodafone it – in my view – has clearly been paying an uncovered dividend for quite a while,” he said.
“They basically lack the cashflow that they used to have when they held the US business Verizon. When they demerged and got rid of Verizon then the cashflow backing the dividend was significantly reduced compared to what it was a few years ago.”
Performance of stock over 5yrs
Source: FE Analytics
Vodafone, which has returned 68.9 per cent over the last five years, is included in the top 10 holdings of some 21 funds in the IA UK Equity Income sector – though others may hold the stock outside of the top 10 holdings.
While Vodafone is a stock Cholwill does not invest in due to its dividend cover, he also avoids stocks based on themes he is cautious on.
One area he does not invest in, for example, are those stocks that are vulnerable to political intervention, such as utilities, particularly with the general election looming. 
“Obviously very topically an example of this is Centrica but I have avoided the company for quite a few years,” Cholwill (pictured) said.
“The reason for that is in the last five years or so they have enjoyed margins of 5, 6 and 7 per cent but if you go back to the days when they were regulated it used to be a 1 per cent profit margin business.
“So, okay, I don’t think it is going to go back to a 1 per cent profit margin business, but perhaps with political intervention including price-capping and so on it is going to settle between the margins it has enjoyed in recent years and the margin that it used to enjoy when it was regulated.”
Back in February, Centrica announced a full-year dividend of 12p, flat on the previous year but noted it expected a “restoration of a progressive dividend when Group net debt is in the range £2.5-£3bn, a level targeted by the end of 2017”.
While Centrica is in fewer funds’ top 10 holdings (five) than Vodafone (21) Cholwill said the company remains widely-held stock among his peers.
He added: “To me energy pricing is very politicised in terms of the price you charge customers and the ability to just switch one account to the next but it is also subsidised by the huge green subsidies that are around and I take a very cautious view on how sustainable government subsidies are.”
The manager highlighted Railtrack as a past example of a company relying on subsidies that can go bankrupt very quickly if the government decides to revoke its investment.
“I think everyone with a long memory will remember companies like Railtrack going bust and that was because suddenly the whole subsidy framework was changed overnight by the politicians,” he said.
“I take the view that politicians come and go and they don’t always honour the promises of their predecessors. Sometimes they look at it fresh and decide to do something different.
“Therefore I am also quite cautious on bus and rail companies because certainly the rail industry is still very dependent on government subsidies and clearly the cost of fares is potentially an issue that could become very politicised.”
Other companies Cholwill avoids are those affected operating in sectors affected by increased regulatory pressures. Cholwill said lenders could come under pressure from increasing regulatory scrutiny, although this is, as yet, speculatory.
“Provident Financial Group is clearly a company that is quite widely held within funds and there I just take a slightly more cautious view,” he said.
The company is in the top 10 holdings of four funds, including FE Alpha Manager and investment veteran Neil Woodford’s recently launched £661m CF Woodford Focus Income.
Performance of stock over 5yrs
Source: FE Analytics
The owner of retail sub-prime lenders Vanquis and Moneybarn, Provident has a very strong five-year performance, returning 260.03 per cent. However, Cholwill remains wary.
“A lot of high APR [annual percentage rate] lenders in the past like Wonga have been scrutinised by the regulator and whilst there is no obvious regulatory risk coming their way soon – I’ve not heard anything – anyone who charges high APRs for lending is potentially vulnerable to the regulator taking a closer look,” he said.
The final area he avoids are companies with strategically-challenged business models, such as education-focused publisher Pearson.
“I guess Pearson would fit into that category which I guess is quite widely held by income funds,” he said. “Obviously at the moment the headline yield is still a premium yield despite the cut that’s been signalled.”
The company announced in its latest results that it would pay out a dividend of 52p overall for 2016 but would rebase its pay-out from 2017.
“It fits into that big blue-chip category that’s had a premium dividend yield for quite a few years,” said Cholwill. “But clearly with the structural changes going on in the US market with textbooks moving from paper to online, as a publisher still very much dominated by print, they’ve been struggling to keep pace with the industry.”
The company, which has struggled over the last two years losing 40.81 per cent, is in the top 10 holdings of three funds in the IA UK Equity Income sector.