Concentration levels across UK equity income investment vehicles are “uncomfortably high”, according to Kepler Partner’s Alex Paget, whose research shows that many trusts – such as Temple Bar, JPMorgan Claverhouse and Merchants – have high levels of dividend dependency in their portfolios.
The research analyst warned that the current dividend trajectory for many of the largest FTSE 100 constituents is unsustainable, given that headline levels of dividend cover have increased due to last year’s post-EU referendum plummet in sterling.
Unless these companies improve operationally as opposed to rally from short-term currency movements, he said they will struggle to increase or even maintain their current levels of dividends over the medium term.
Source: AJ Bell Dividend Dashboard
“Research from AJ Bell [above] shows that dividend cover across the FTSE 100 is 1.6x. However, it is even lower across the 10 largest dividend-paying stocks in the index, which account for 58 per cent of total UK dividends and have an average dividend cover of just 1.1x earnings,” Paget (pictured) pointed out. 
“This leads to a very odd situation whereby there are only a few UK stocks that offer a higher yield than the index itself, and it is those stocks that arguably have the most challenged dividends.
“Take Royal Dutch Shell – which accounts for a hefty 14 per cent of total UK dividends – it yields 6.6 per cent, but has dividend cover of 0.9x, which suggests that unless something changes, the company’s dividend is unsustainable.”
While the research analyst said this presents a strong argument against passive investing in the market area, his analysis suggests similar concentration issues arise amid many actively managed UK equity income vehicles.
For instance, Paget said 87 per cent of UK equity income investment trusts own BP while 83 per cent hold Royal Dutch Shell.
In terms of the overall percentage of sector assets, his research shows that 25.13 per cent of capital in the IT UK Equity Income sector is invested in just 10 stocks and, between these, their dividend cover averages at 1.17x. Within the open-ended IA UK Equity Income sector, he said 28.99 per cent of the peer group is invested in 10 stocks. Of these, the average dividend cover is 1.04x.
“Whilst UK income trusts are in a better relative position, if any of those popular UK income stocks cut their already barely covered dividends, it would have a disproportionate effect on the total income generation within both the open- and closed-ended UK equity income sectors,” the research analyst warned.
What’s more, he said a high percentage of the pay-outs from funds themselves is dependent on just a small handful of UK mega caps.
Paget’s research shows that, if Royal Dutch Shell were to stop paying a dividend, the total income generation within the IA UK Equity Income sector would fall by £103m, or 4.44 per cent of total dividends. His data also shows that the five most popular stocks in the sector account for 20 per cent of all dividends paid, while the top 10 accounts for 33 per cent.
“In investment trust world, in the AIC UK Equity Income sector, total levels of dividend dependency on the 10 most popularly-held stocks is slightly lower than the open-ended peer group, accounting for 30 per cent of total portfolio income,” the research analyst continued.
“Furthermore, the average dividend cover across those 10 companies is also higher than in the IA UK Equity Income sector. Nevertheless, 10.6 per cent of all revenue within the peer group is generated by the two oil majors, Royal Dutch Shell and BP.
“We note that five trusts in this sector derive more than 15 per cent of their total portfolio income from Shell and BP: Temple Bar (19.35 per cent), JPMorgan Claverhouse (18.00 per cent), JPMorgan Income & Capital (17.72 per cent), Merchants (17.47 per cent) and JPMorgan Elect Managed Income (16.80 per cent).”
Performance of trusts vs sector over 5yrs
Source: FE Analytics
That said, he pointed out that investment trusts do have a notable advantage over their open-ended peers in that they can retain up to 15 per cent of their annual earnings to smooth dividends.
This means that, if some of their holdings cut their dividends or cease paying them altogether, investors are less likely to shoulder the entire impact.
“It appears that many boards and managers in the peer group have been preparing for a more difficult market for UK dividends,” Paget said. “According to our analysis, revenue reserve cover – as a multiple of each trust’s previous year’s dividend – is currently at its highest level in 10 years at 0.92x.
“Close to 80 per cent of trusts in this group have paid a covered dividend in each of the past three years and managers and boards have been withholding ever increasing levels of revenue – suggesting they are expecting a more turbulent time.”
His research shows that, in 2012, the average trust held back 3.27 per cent of their revenue returns per share. In 2016, this increased to 12.5 per cent.
“While these are undoubtedly positives for investors in the investment trust space, the effects of the more difficult earnings environment have weighed on trusts in the sector,” the research analyst continued.
“The average year-on-year revenue return growth per share for the peer group is a clear illustration of this, having steadily fallen from 12.1 per cent in 2011 to 4.2 per cent in 2017.
“If this growth continues to slow or turn negative, many trusts may have to dip into their revenue reserves to maintain their dividend growth. While that isn’t sustainable over the long term, helping managers smooth their dividends to shareholders in more difficult years that is what the revenue reserves are there for.”
Overall, Paget said investment trusts are better able to cope with concentration risks and challenging underlying dividend cover relative to their open-ended peers.
Given that the average trust in the IT UK equity Income space also has close to a full year’s dividend held in reserves, he pointed out that most trusts should be able to keep growing their dividends for investors even if some of their constituents were to cut their pay-outs.
“Whilst we believe trusts in the AIC UK Equity Income sector can be seen as relatively robust from a dividend point of view, they are – as a result of the high levels of concentration and similarity of holdings – by no means immune if certain FTSE 100 companies lowered their dividends,” Paget warned.
“The ‘other’ effect of a dividend cut is usually a large share price decline (BP’s cut in 2010 following its notorious oil spill is testament to this) and therefore many investors’ capital – which we believe is highly important to the whole income puzzle – could well be at risk.
“As such, at this point in time it would seem prudent for investors to diversify their income stream away from the most popularly-held dividend payers in the index. Obviously, this can be achieved by looking outside the UK for equity income – however, we believe that there is also a strong argument for investing in UK mid and small caps for dividends.”
Examples of UK equity income trusts Paget believes are attractive include Diverse Income Trust, Chelverton Small Companies Dividend, Standard Life Equity Income Trust and Finsbury Growth & Income Trust.