With sterling strengthening in recent months, investors should be aware of the risk it poses to UK equity income holdings, according to Kepler Trust Intelligence’s Callum Stokeld.
Confidence in the UK economy and sterling was rocked by the EU referendum of 2016, as the result revealed that voters wanted to exit the bloc.
Sterling has struggled in the years since the referendum as uncertainty over a post-Brexit relationship between the UK and its biggest trading partner has dragged on.
Until recently.
Having fallen by 14.15 per cent in the three years following the referendum, in euro terms, the currency has risen by 6.73 per cent in the past three months.
Performance of sterling in euro terms over 3mths
Source: FE Analytics
The currency has rallied as prime minister Boris Johnson agreed a deal with EU negotiators and called a general election – which polls currently indicate he will win – to secure backing for it.
As such, Kepler investment trust analyst Stokeld said investors should beware of any impact a strong rally in sterling could have on their equity income holdings.
“Whilst a rise in sterling will make a trip abroad relatively cheaper, it will likely pose some challenges to earnings and, therefore by extension, dividends of the FTSE All Share index.
“Around 70 per cent of earnings in the FTSE All Share come from overseas. When sterling falls, this boosts reported profits, while the opposite is also true.”
The analyst said investors might hope that companies absorb any impact of a sterling rise by raising their payout ratios, having happened in the past.
Stokeld said the below chart shows that payout ratios have a positive relationship with sterling and that when earnings fall, companies have to pay out a greater proportion of income to maintain or grow dividends.
Source: Kepler Trust Intelligence
“Whilst payout ratios have been higher over the past 10 years, at 80 per cent, we are in precarious territory,” said Stokeld, noting that the current ratio is 36 per cent higher than the median level.
“The last decade has itself seen average payout ratios inflated by the effects of the oil price crash and the financial crisis,” he added.
“To us, this suggests limited room for manoeuvre for UK companies. Considering the low productivity growth in the economy and low levels of capex [capital expenditure], it has to call in question the willingness and ability of companies to maintain or raise their dividends in the face of a decline in earnings.”
In such an environment, investors may want to opt for equity income investment trusts rather than open-ended funds, which are forced to pay out all income
Trusts, he noted, are able to build revenue reserves allowing them to pay out in leaner years, where income streams may be impaired by falling earnings, stretched payout ratios or economic contraction.
“Rallies in sterling have historically tended to lead to UK equities outperforming global markets in sterling terms, so there is some comfort for UK equity investors here,” he said.
“However, if we were to see a rally in sterling, this could put a strain on dividends in UK large-caps and could certainly impede dividend growth or precipitate dividend cuts.”
And with dividends concentrated in a handful of names any decision to hold or cut payouts could have “seriously negative consequences for UK equity income investors”, said Stokeld.
The analyst said trusts in the IT UK Equity Income sector were typically well covered with an average dividend cover of 1.26x.
“Shareholders have what unitholders do not – an income safety net,” he said.
“There is, of course, no right or wrong answer as how much reserves should be held, any more than there is to what level of dividend should be paid out.”
One trust highlighted by Stokeld is the £1.8bn City of London Investment Trust, which has a yield of 4.6 per cent and has grown its dividends for 53 years in a row “irrespective of wider conditions”.
“Job Curtis has been in charge since 1991 and has himself a track record of 28 years of dividend increases,” he said.
“Income generated by the trust’s portfolio has, of course, grown over this time, but the board has used the revenue reserve as a supplement on seven occasions to ensure that investors continue to see growing dividends.”
Income earned on £1,000 investment in City of London over 10yrs
Source: FE Analytics
As the above chart shows, £1,000 invested in the City of London investment trust would have generated £635.93 in income.
Alternatively, some trusts can operate with a lower level of headline dividend cover because they invest in companies with higher yields, said Stockeld, such as the £260.4m Troy Income & Growth trust (yield: 3.3 per cent).
Managers Francis Brooke and Hugo Ure have grown dividends in nominal and inflation-adjusted terms every year since Troy took over the trust in 2009.
“The managers have a concern for capital preservation and aim to identify ‘quality’ companies with strong balance sheets and – generally – non-cyclical earnings streams,” said Stokeld. “Thus, their actual portfolio has a superior level of dividend cover relative to the FTSE All Share.”