I’m sure you’ve all read, or heard, the Danish literary fairy tale of the Ugly Duckling by author Hans Christian Andersen.
It tells the story of a duckling who, when hatched along with his brothers and sisters, is ridiculed and ostracised because they perceive him as ugly. He wanders alone through the autumn and winter, and suffers from fear, loneliness, and sadness as he cannot fit in. In the end, the swans show him that he is not a duck; he is, in fact, a beautiful swan.
The unhappier aspect of the story reminds me a bit of UK plc in the past few years, but it particularly resonates in the UK equity income sector. Having originally been the darling of every investor’s eye (it was originally a swan!), the past decade has been anything but kind to this sector as Brexit, the strong outperformance of growth-style investing, and the Woodford debacle all hit sentiment hard. The rise of alternatives in the multi-asset and global equity income market meant it was no longer the first stop for an investor to build a portfolio for the long-term.
Covid also hit hard – in total, dividends paid to investors fell 44% to £61.9bn in 2020. But the recovery was swift, with dividends jumping some 46% in 2021 – figures from Link Group show that headline dividends are now estimated to reach £97.4bn in 2022.
UK equities prove more resilient
Things do look to be changing as UK equities have been more resilient than many other world markets in 2022. This has occurred as inflation has hit multi-decade highs in the major economies such as the UK, US and Germany and interest rates have risen sharply. There has been a clear preference for the international nature of the FTSE 100 as a result.
In addition, the UK’s exposure to value sectors like financials, oil, miners, and energy has become more of a blessing in recent times as rising inflation and interest rates have favoured these sectors – by virtue of many being able to pass on inflationary pressures to their customers.
Gam UK Equity Income manager Adrian Gosden points to three specific tailwinds for the sector in 2023. He says not only are UK dividends on the rise following the cuts of 2020, but also that the market continues to see a large amount of corporate activity – reflecting both the fall in sterling and the undervalued nature of the UK market as private equity firms continue to buy UK businesses and take them off the market. He also points to the unprecedented amount of share buybacks.
Speaking on buybacks, he says: “UK companies, principally in the financial and energy sectors, having paid their dividends and with healthy balance sheets, are buying themselves. These businesses cannot make acquisitions in the wider market because it is too expensive and therefore, given the low price of their UK shares, they are choosing to buy themselves. We regard this as an attestation to the company’s value. Further, share buybacks matter to investors because they reduce the denominator on which dividend per share and earnings per share are calculated. As a result, earnings per share and dividend per share rise.”
Inflation in the UK currently stands at 7.6%. Even if it falls to half that number in the next 12 months, the dynamic between growth and value changes. This is where a number of old-fashioned UK equity income funds with exposure to numerous resources benefitting from inflation – the likes of energy and mining companies – could find themselves as the popular choice once again.
But there remain dangers – not least the concentration of dividends in a few leading companies. With this in mind, here are a few options to consider in the market.
Traditional equity income fund
Here I’d look to the likes of the Artemis Income fund, which currently has 82% of the portfolio in large caps, with names like BP, AstraZeneca, and Pearson in the top 10. A stalwart for two decades, the fund is designed to offer a diversified, eclectic mix of cashflows from different companies to ensure a sustainable and durable income. The fund currently yields 3.94%.
Multi-Cap
Those who want to avoid the concentration of dividends in the UK market might consider the IFSL Marlborough Multi Cap Income fund. Manager Siddarth Chand Lall invests in a combination of FTSE 350 and much smaller companies, with a premise that these firms tend to outperform over the long run. The manager sources ideas from the team and a network of brokers, studying financial statements and using models to test the sustainability of dividend payments. Management meetings are key and 65% of the fund is in stocks with a market cap of less than £1bn.
Value/balanced approach
Gam UK Equity Income co-manager Adrian Gosden’s process for selecting and valuing companies is based on how much spare cash each business generates and their ability to pay dividends with this cash. Idea generation starts with a basic filter of the UK stock market to find companies with these good free-cash flow metrics. From here, they will do an industry assessment to understand what environment a company is operating in, including on regulatory considerations, competitor analysis, and pricing power.
Investment Trust approach
Murray Income Trust, managed by Charles Luke, consists of a portfolio of high-quality companies, which can thrive in any economic environment. This appears to have been the case as the trust was one of the stand outs in terms of protecting dividends during the pandemic. The portfolio has an excellent long-term track record and yields 4.17%.
This article was written for Portfolio Adviser by Darius McDermott, managing director of Chelsea Financial Services
