Why divi hunters must do their homework

26th April 2010

UK Equity Income funds have consistently been among the top sellers in the market and the sector houses several of the industry's best-known managers.

But commentators are now concerned about so-called clustering in these portfolios, with managers forced to seek yield in the same few stocks.

Dividend cuts across UK companies have curtailed options for income funds, with the situation largely down to financials.

Several banks have cut or suspended payments as they attempt to repair balance sheets and with these stripped out, over two-thirds of the UK market yield comes from just 15 stocks.

A recent report from analyst firm Standard & Poor's said this remains an issue and managers are currently finding better prospects for dividend growth among small and mid cap stocks.

According to its data, those top 15 companies currently account for 45% of the average equity income fund but the remaining 55% is spread across 600 companies. 

Some might argue dividends are only part of total return but a recent article on The Motley Fool emphasises their importance in areas like saving for retirement.

Author Jordan DiPietro says that when interest rates on Certificates of Deposit and savings accounts were above 5%, producing a decent retirement income was a fathomable task.

But the financial collapse of 2008 has pushed rates so low that most investors are earning just about nothing in their primary money market funds.

"The best move you can make is to invest part of your portfolio in dividend-paying stocks," he adds.

"Not only do they provide you with a recurring stream of income, they also offer room for growth. This is critically important as your portfolio needs to keep pace with inflation."

He notes stocks such as Intel, rarely thought of as a yield play but actually increasing its dividend payout over the past five years by 26%.

And this is no fluke. From 1957 to 2003, when reinvesting dividends, the S&P's 100 highest-yielding stocks outperformed the market by an average of three percentage points.

Of course, not everyone agrees with this assessment and the comments on the piece provide opposing views. One poster says dividend rates should not be a big part of stock purchase decisions and distributions are a sign management has no good ideas on re-investing earnings.

The UK picture

If you are a fan of the dividend story, what prospects is the UK providing after such a tough period?

Among fund managers, Nick Purves, who co-manages Schroder Income, highlights the strong appeal of UK equities relative to corporate bonds in the current environment.

At present, there are a number of well-known, long-established names like AstraZeneca, GlaxoSmithKline, BP and Vodafone, where equity is yielding significantly more than the credit. On Vodafone for example, the dividend yield is around 6%, whereas its corporate bonds are yielding just 3.8%.

In general, Purves believes the outlook for dividend growth is now improving, particularly as so many companies rushed to preserve cash last year.

"Given the nature of this economic downturn and the corresponding squeeze on financing, dividends were seen as an easy source of liquidity for companies about 18 months ago," he adds.

"Unlike in the 1990s recession, this resulted in aggressive cuts to dividends and a significant fall in UK payout ratios (the proportion of earnings distributed to shareholders)."

The situation now is that, after a torrid couple of years, payout ratios are coming off a low base and profits, while meaningfully below trend, are clearly improving.

Dividend growth on the cards?

If profits can continue to rise and companies start to feel more confident about their access to credit, Purves believes we could see earnings and payout ratios rising at the same time and the advent of some fairly strong dividend growth among UK shares.

Despite this improving outlook however, uncertainty remains on UK dividends and several groups have launched overseas income products to access alternative sources of yield.

Schroders recently announced plans to launch an Asian Income Maximiser fund for example, adding a covered call strategy to its existing Asian Income product. Manager of both Richard Sennitt says Asia as a region offers investors good diversification in the form of more companies from which to draw income.

"For example, eight stocks in the FTSE 350 make up 50% of the dividend income, whereas more than 35 companies contribute the same proportion in the MSCI AC Pac ex Japan sector," he adds.

"Recovery in Asia has been driven by large amounts of self-help, both fiscal and monetary, and the region is well positioned to benefit from any global recovery.

"The strong profits growth being seen this year should be positive for dividend payments.

A warning to dividend chasers

Wherever you find your dividends, due diligence on how sustainable they may be is clearly more important than ever.

A recent article on The Motley Fool cautions against so-called dividend traps , with many companies enticing investors with the promise of fat payouts only to cut them down the road.

Author Anand Chokkavelu says he always tries to look behind the surface numbers, particularly at figures such as the payout ratio.

If he sees a ratio greater than 50%, he tends to get suspicious – and when it goes above 100%, a company's earnings are not enough to cover its dividends.

Worse than a payout ratio greater than 100% is a negative figure as it means the company is paying out dividends despite reporting a loss.

"Due diligence is important in any environment but it's especially key now, when we can scoop up high-dividend plays that could form the core of our portfolios for decades to come," he adds.


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