Investing for income? You could do a lot worse than following the lead of the UK’s top fund managers.
March marked the eighth year of record low interest rates. While just a few years earlier you could walk into a high street bank and sign up to a savings account paying in excess of 5% interest, March 2009 marked the end of real inflation-proofed returns from cash. Bond yields dwindled – in some cases even went negative, leaving income investors with equities.
Some sectors cut dividends following the recession; banks were ordered to fix-up their balance sheets and are only just returning re-introducing dividends. Lloyds (LLOY) made headlines recently after promising to up its pay-out. Lloyds reintroduced dividend payments in 2015 after a seven year hiatus.
Natural resources stocks came unstuck following the commodities crash of 2015, with Anglo American (AAL) and Rio Tinto both cutting dividends.
But the outlook is more rosy for shareholders in 2017. Just last month, the latest Dividend Monitor from Capita Asset Services revealed that dividend pay-outs have risen 14.5% over the past year – with pay-outs in the second quarter of 2017 hitting £33.3 billion, an all-time high.
Even stripping out the currency boost, underlying dividends rose by 7.8% compared to the same three months in 2016, thanks to increased pay-outs from mining stocks, consumer goods companies and even financials.
So where are the professionals finding their best income opportunities? Using the Morningstar Portfolio tool, we built a list of the 18 most popular UK equity income funds, including funds run by Neil Woodford, Invesco’s Mark Barnett, Royal London’s Martin Cholwill and Threadneedle’s Richard Colwell among others.
Then, using the Morningstar X-Ray tool, we looked at the overlap between these 18 top rated funds and identified the dividend stocks most widely held by the professionals.
GlaxoSmithKline (GSK)
Glaxo is found in 15 of the top 18 UK equity income funds, with Threadneedle UK Equity Income taking the largest bet on the pharmaceutical at 6.22% of their portfolio. Glaxo is currently yielding 5.32%.
Morningstar equity analyst Damien Conover says GlaxoSmithKline has used its vast resources to create the next generation of health-care treatments. The company's innovative new product line-up and expansive list of patent-protected drugs create a wide economic moat, or large competitive advantage over peers.
Conover expects the company will be able to fund its dividend payments over the next decade, but does not expect much of an increase to the dividend over this period.
AstraZeneca (AZN)
Astra is found in all 18 of the funds’ portfolios. Threadneedle UK Equity Alpha Income has the largest weighting of the funds, with a 7.32% allocation to Astra. AstraZeneca has built its leading presence in the pharma and biotech industry on patent-protected drugs and a promising developing pipeline.
Astra continues to generate robust cash flows, says Conovor, However, the firm needs to offset lost cash flows from products losing patent protection over the next couple of years to generate enough cash flow to fund the dividend. The dividend yield sits at 4.47% today.
“While we project that the company will not need to cut the dividend, there is not much room for error,” he added. “Also, after the company made several acquisitions over the past few years, we don't expect it will make any major ones given the lack of excess cash generation following the dividend payment.”
BP (BP.)
BP is in 13 of the funds. JOHCM UK Equity Income is the largest investor, with 6.52% allocated to the stock. With the Deepwater Horizon oil spill largely resolved, BP is now turning its focus to positioning the company to compete in a world of lower oil prices.
Its first step is to improve its cost structure and reduce its capital outlays so that it can cover its dividend at $55 a barrel oil by the end of this year. The yield is currently 6.56%.
Morningstar analysts estimate that this goal is slightly ambitious and a full-cash dividend coverage by 2019 is more likely.
HSBC (HSBA)
12 of the top-rated UK equity income funds hold HSBC. SLI UK Equity High Income has a 6.89% weighting, the largest of all the funds. HSBC’s strengths are its positions in the U.K. and Hong Kong banking systems, as well as its overall leadership role in trade finance.
Much attention has been paid to HSBC’s dividend, its future prospects, says banking analyst Derya Guzel. The dividend yield sits at 5.09%.
“We consider HSBC’s financial health to be very good,” she adds. “However, we estimate HSBC will return about 70% of earnings through dividends on average over the next three years, suggesting that future dividend increases are extremely unlikely until the bank’s earnings power can fully recover.”
Royal Dutch Shell (RDSB)
Shell is held in 11 of the funds. JOHCM UK Equity Income is the largest investor, with 8.66% of its portfolio in Shell. Shell is embarking on the necessary steps to compete in a world of $60-per-barrel oil, working to reduce its cost base, which has become bloated during the past five years, by reducing head count and improving its supply chain. After debt reduction, Shell prioritises paying a dividend. The stock yields 6.29%.
“Shell currently offers a scrip dividend, but we anticipate that it can return to paying a full cash dividend by 2019,” says analyst Allen Good. “By our estimate, Shell can cover a full cash dividend with free cash flow at oil prices of $58 a barrel beginning in 2018.”
British American Tobacco (BATS)
British American is held in 12 funds, with SLI UK Equity High Income allocating the largest portfolio slice at 5.14%. BATS is currently yielding 3.16%. There are two sources to BATS’ wide economic moat: intangible assets and a cost advantage.
Both occur in the tobacco business and have not, yet, transferred to the company’s platform of next generation products. Tobacco brands' intellectual property has created loyalty among tobacco users toward the brands they enjoy. British American has an impressive brand portfolio that is fairly evenly balanced across price points.
“With a dividend pay-out ratio in the mid-60 percentage, British American is roughly in line with its European competitors but below the 75%-80% targeted by its U.S. counterparts,” says analyst Philip Gorham. “In the long term and as developing markets mature, we expect significant growth in the company's dividend.”
