Investors should be careful not to become over reliant on dividends from UK equities when constructing portfolios, according Sarasin & Partners.
It’s not hard to see why the UK equity market looks attractive to income. When compared to other geographic regions it pays one of the highest income yield – at more than 4%, according to data from Sarasin. Dividends from UK companies rose more than 7% in 2017 while US dividends grew 5.1%, according to the Janus Henderson Global Dividend Index.
However, Sarasin points out UK companies, on average, pay out almost 70% of their earnings in dividend payments. This makes for a high income stream, but the it can mean less money is re-investd in the business to sustain future growth. Therefore Sarasin says that investing in UK equity income may not be the best use of capital within a portfolio.
James Hutton, portfolio manager at Sarasin & Partners says: “If UK companies are paying out almost 70% of their earning in dividends this tells us two things. One is that you only need a relatively small fall of earnings in the UK market for dividends to be under pressure.
“Secondly, there is a relatively small part of earnings to be reinvested back into the business, for then the next five to 10 years growth. That explains why having a large structural allocation to the UK stock market might not necessarily to be the best allocation of the capital when you make investment decision in the long term.”
UK Equities Income are Not Diversified
Hutton also points out that the UK market is not particularly diversified, and doesn’t have a large exposure to the tech sector, for example.
“If you look at the sector allocation, do I really want to have less than 2% of my portfolio exposed to information technology, when technology is changing our life? Mobiles phones and digital gadgets are an essential part of our everyday life, wouldn’t we want our investment portfolios to reflect this?”
While the UK is underweight in some sectors, this means it is also overweight in other. For example, the energy sector dominates a large part of the UK equities market. Recent research by Sarasin showed that oil and gas companies represent 19% of all the income paid out of UK equities. The top 10 individual companies in the UK account for 54% of the income that you receive in the country.
“Whatever views you have on climate change, consumer attitude towards renewables are changing. Therefore, the success of energy companies could be challenged. Having a such a large part of them in your portfolio may not be the right decision long term,” said Hutton.
He added: “If income is important for your investment, diversification of income is important too.”
Despite globalisation – and the international flavour of the FTSE100 - the UK remains a relatively small component to global growth. For example, the UK accounted for less than 5% of global GDP in 2014, six times smaller than the China’s economy, according to data provided by Sarasin and the World Bank. This is compared to the US, which accounted for 23% of the global GDP, followed by China and Japan with 15% and 6% share of global GDP respectively.
The UK also remains a very small part of the world investable universe, in terms of equities, with a 6% share of the global equity market.
3 Portfolio Constructions for Different Time Horizons
According to Sarasin’s portfolio suggestions, investors who have a shorter time horizon – from zero to 18 months – should look at including cash, certificates of deposit, and short-dated government bonds. These fixed income investments should hopefully improve on the returns from cash.
For investors with a medium-term horizon: from 18 months to five years, Sarasin suggests a portfolio made up of 60% of gilts and corporate bonds. Equities would play a smaller part in the portfolio.
For investors who have long-term investment view of five years or more, the greatest risk to their portfolio is the impact of inflation. Therefore, to maintain the real value while providing sufficient income, investors should invest in a larger proportion of equities in their portfolios.
“We see global equities providing more opportunities than UK equities, in terms of income,” said Hutton.
Mark Whitehead, fund manager of Securities Trust of Scotland (STS) echoes Hutton's views, saying a global remit has natural advantages for income investors.
"The top 20 dividend stocks of the FTSE All Share account for 64% of the total pay-out. Widen this to the MSCI Europe and the figure drops to 39%. For the MSCI World Index the top 20 dividend stocks pay out just 18% of the total. The ability to go global give you more opportunities," said Whitehead.
