The increasing concentration of dividend risk as well as capital risk in the post-quantitative easing era are some of the issues that UK equity income sector investors need to be aware of, according to Neptune’s Robin Geffen. 
The Neptune Investment Management founder and chief executive said he had decided to sell two of the income funds his mother had invested in given concerns over dividend risk within income portfolios and the poor dividend cover figures across the sector.
“People are not talking about that but dividend cover is something that should be at the back of your mind, particularly for people in retirement or approaching retirement,” Geffen said.
“Also, there are still funds out there using a single company to deliver more than 20 per cent yield of the fund and there are still funds out there which have more than 75 per cent of their total yield coming from the top 10 high-yielders.”
Data from Link Asset Services' UK Dividend Monitor showed almost a quarter of the total payout in the first quarter of 2018 was once again paid by the oil majors Shell and BP.
The top five largest companies in the main FTSE All Share index represent 47 per cent of total dividend payments, with the next 10 biggest firms accounting for 30.4 per cent.
Dividend concentration in the UK
Source: Link Asset Services
Warning of the risks of concentration of yield, Geffen said the funds with the highest dividend risk performed worse in the market correction earlier this year.
“There is a sort of illusion about certain stocks that are bond proxy stocks which people have bought over the last seven or eight years as a reaction to the quantitative easing scenario after the global financial crisis,” he said
“Since then, many people have been relying on bond proxy-type of stocks but the world has changed: we expect two more rate rises in the US and the Bank of England is beginning to move towards a further interest rise in the UK.”
Given those changes, the manager believes the current moment is not the best to be relying on the UK consumer sector for yield.
“In our views, tobacco is simply not a safe place to invest. Nearly 60 per cent of the funds own Imperial Brands and British American Tobacco (BAT) and over a third of funds own at least one of them,” he noted.
“BAT is down 21.9 per cent and Imperial Brands is down 11.6 per cent; so even if you have 4 or 5 per cent yield, you have lost capital this year. That is one of the reasons I’ve had to sell two of the funds my 96-year-old mum invests in.”
Geffen is underweight consumer staples and consumer discretionary in his Neptune Income fund, has no exposure to utilities or to real state and has less exposure to energy than other income funds with just a 3 per cent weighting in oil companies BP and Royal Dutch Shell.
When it comes to the areas where he is finding opportunities, the fund is overweight material stocks and the technology sector due to the high beta and high growth characteristics of the IT industry.
UK dividends
Source: Link Asset Services
Despite the 20 largest contributors to the UK equity income sector having an average yield of 5.57 per cent, Geffen noted he is getting a 2.27 per cent yield from the five IT stocks he holds in the portfolio.
The reason, he said, is that he is avoiding those “most-widely held” stocks as these barely have a dividend cover of about 1x.
“Our tech holdings have a dividend cover of 2.37x and they have grown their dividends 20.28 per cent on a five-year rating. The 20 largest holdings in the UK income sector have only grown their dividend by 3.5 per cent annualised over that period,” he explained.
“So, if you look at our IT stock holdings, they have grown earnings on average 4.6 per cent per annum whilst the 20 most widely held stocks in the equity income sector have actually shrunk earnings by 3.9 per cent per annum over the last five years.”
Not only have IT stocks grown earnings but Geffen said they have a pay-out ratio of 60.93 compared with a pay-out ratio of 95.50 for the top 20 holdings in the sector, which means IT stocks have room to increase their dividends.
“If we see a rise in interest rates in the UK this will mean an increase in the cost of borrowing [and] the top 20 holdings held across the UK equity income sector are going to move into a negative dividend cover. They will see negative earnings growth, the dividend cover will disappear and the payout ratio will also go over a 100,” Neptune’s founder highlighted.
As such, he said the tech holdings he owns not only have the ability to go up more than the market but they also have some defensive qualities that sectors such as consumer staples, consumer discretionary, real state or healthcare currently don’t have.
“The most worrying thing that has emerged in our analysis of the sector recently has been the capital sacrifice investors have been forced to make to produce high yield,” the Neptune founder said.
“The five largest income generating funds have generated a capital loss and we have seen how the returns have been like over the last three years, another reason why I sold two of my mother’s income funds earlier this year.
“The industry has got a retrospective mindset driven entirely by the mentality of QE but this is a time to be looking for what has defensive qualities.”
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Over five years, Neptune Income has delivered a total return of 52.16 per cent compared with a gain of 51.29 per cent for the FTSE All Share benchmark and a 50.99 per cent gain for the average IA UK Equity Income fund.
Neptune Income has an ongoing charges figure (OCF) of 0.86 per cent and a yield of 3.74 per cent.