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Ups and downs for UK dividends

03 February 2015

As the traditional sectors for providing generous dividends face tough conditions, investors are looking elsewhere for their market-beating yields.

Before the financial crisis, investors in search of income knew that certain sectors could be relied upon to deliver generous dividends and market-beating yields. Banks were always at, or near, the top of the list; food retailers and utilities were good bets, too, as were the big pharmaceutical companies and oil and gas majors.

Today, the picture is quite different. Most banks struggled to survive the financial crisis and, although HSBC still offers a reasonable yield, the sector as a whole has little appeal for the income investor.

As for the food retailers, 2014 was their annus horribilis. Tesco is forecast to pay a dividend of around 4.6p for the 12 months to February, a third of the 14.76p it paid out at the same time in 2014. Analysts do not expect a recovery any time soon, with the dividend for 2015 expected to be just 5.3p 1. Tesco delivered the most headlines last year but Morrisons was not far behind, and Sainsbury’s also signalled that dividends will be lower in the future.

‘UK supermarkets are suffering from structural changes in the market, and it will take a long time for them to re-engineer their business models,’ says Justin Cooper, head of shareholder solutions at Capita Asset Services.

The outlook is far from certain for other erstwhile income sectors, too. Utilities have become political footballs and their fate will not be known until after the general election.

Oil and gas majors BP and Royal Dutch Shell have traditionally been among the highest dividend payers in the market, but last year they were hit by rising costs and a strong pound in the first half, followed by falling oil prices in the second. If lower oil prices continue, dividends are almost certain to be affected.

And yet the future is not all bleak. Capita predicts that underlying dividends in the UK will rise 5.5% to £83.7 billion this year, having increased by less than 2% last year.

Over the long term, too, dividends have been growing steadily, as Chris Reid of Majedie, manager of the St. James’s Place UK Income fund, points out. ‘Income from the FTSE All- Share has increased by an average of 7% per annum over the past 10 years.We have some fantastic income providers in the UK,’ he says.

Dividend growth across the market is clearly a positive trend, but deeper analysis provides further clues about where best to look for income, not just now but in the future. FTSE 250 dividends are increasing significantly faster than those in the FTSE 100, albeit from a lower base.2 In the third quarter of last year, for example, the main index accounted for almost 89% of total pay-outs, but dividends fell 1.1% year-on-year. The FTSE 250 accounts for just over 9% of total pay-outs, but dividends within the index rose 7.6%.

‘The FTSE 100 is unusual because so many companies report in dollars or euros and derive profits from overseas,’ says Cooper. ‘So when the pound is strong, dividends suffer, particularly if they are declared in dollars and then converted to sterling. Equally, these companies are more sensitive to global economic turbulence. Mid-cap stocks are more domestically oriented, and tend to be more cyclical, so they do better when the UK economy is recovering.’

Housebuilders are an example of this trend. Not only have they recovered dramatically from their post-crisis lows, but they are also determined to adopt a more disciplined approach to capital – and that means returning more money to shareholders through dividends rather than investing in overpriced land. In other words, they are making sure that the amount they pay out in dividends is well covered by earnings. Dividend cover, calculated by dividing earnings per share by dividends per share, is a key measure for income investors; the higher the cover, the greater the security of the dividend payment is likely to be.

‘When you are looking for dividend growth, the most important thing to look for in terms of sustainability is cover,’ says Alex Stewart from broker Shore Capital. ‘On that basis, buying the highest-yielding stocks may not always be the best policy. Investors should instead focus on security of income flow. A company such as food producer Cranswick, for example, has raised its dividend every year since its IPO (initial public offering) in the 1970s. That’s sustainable growth for you.’

On a sector basis, tobacco stocks, large alcoholic drinks companies, telecoms providers and transport groups are often mature businesses, with a tendency to reward their investors. The first two may raise eyebrows among ethical investors, but smoking and drinking continue to deliver profits, while telecoms stocks such as BT, Vodafone and even TalkTalk tend to generate plenty of cash.

Vodafone has traditionally been one of the largest dividend payers in the UK – in the first quarter of last year it returned almost £16 billion to investors following the sale of its stake in US mobile operator, Verizon. Now a smaller business, it has pledged to remain a generous distributor of dividends in the future.

Of course, predicting where income growth will come from is not an exact science. Majedie’s Reid adopts a focused approach, seeking out companies that are likely to pay market-beating dividends in the future: ‘You have to look for companies that are raising their game. We look at their six-year history and their forecasts for the next three years. We then carry out four tests: how they make money, the strength of their balance sheet, their competitive position and their valuation. The idea is that the 60 or so companies in our fund will leapfrog the competition over three years.’

Reid’s approach is highly specific but, like other income seekers in the market, he believes earnings cover is crucial.

‘It is a question of looking at the dividend, seeing how much it costs and how much it is covered. For us, the cash dividend cover should be 1.3 times and rising.’

With interest rates still at historic lows, the search for income is increasingly important. Against that backdrop it is worth noting that, even though income from the FTSE 100 fell last year, the index is still yielding around 3.5%. It is reassuring to know that the main index still beats bank accounts hands down.

1 www.digitallook.com

2 Majedie Asset Management, December 2014

The information contained within this report, does not constitute investment advice. It is not intended to state, indicate or imply that current or past results re indicative of future results or expectations. Full advice should be taken to evaluate risks, consequences and suitability of any prospective fund or investment. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place.

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. Equities do not have the security of capital which is characteristic of a deposit with a bank or building society, as the value and income may fall as well as rise.

FTSE International Limited (“FTSE”) © FTSE 2015. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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