The ability of UK Equity Fund managers to identify sustainable dividend payers will be crucial if the equity bull market runs out of steam and dividend cover fails to improve, according to research highlighting problems facing the products across Europe.
Equity income products across Europe are currently under pressure, a Cerulli report says.
“With dividend cover at a low, some companies may cut or scrap on dividends soon. This will make it difficult for equity income funds to deliver decent yields,” says Brian Gorman, international analyst at Cerulli Associates Europe.
The FTSE 100’s forecast dividend yield is currently 4.2%, or 1.74 times earnings, analysis by AJ Bell shows. Dividend cover should ideally be at least two times earnings, says investment director Russ Mould.
"A lot of UK managers have moved further down the market cap spectrum where dividend cover can be much stronger."
“While that is thinner than ideal, the cover ratio represents a welcome improvement from the 1.28 times low of 2015, a warning sign which presaged multiple cuts in 2016, notably from the banking, mining and food retail sectors.”
VULNERABLE AREAS
While weak sterling has boosted dividends in some sectors, but domestic stocks and those in the retail sector have suffered, according to Jen Causton, investment manager at Architas.
Taylor Wimpey and Persimmon could be tested in the event of a housing downturn or recession, says Mould. “Both could fund dividends from cash reserves although traditionally builders like to buy land cheaply during downturns to set themselves up for the next recovery, so they could then have a tricky choice to make.”
Telecoms are an area of concern for Sam Ford, manager of the M&G UK Select Fund.
Ford says dividend cover appears to be stretched in the sector because competition can evolve quickly, pricing power is low, and businesses require sizable amounts of capital to grow and sustain profits.
WEAK STERLING
FTSE 100 exposure has helped some underlying managers in the BMO GAM multi manager range, says investment manager Scott Spencer (pictured).
“However, a lot of the UK underlying managers have moved further down the market cap spectrum where dividend cover can be much stronger and less impacted by external factors such as the oil price or currency moves.” Spencer lists financials as a sector with the potential to raise dividends from current low levels.
Commodities, which account for a sizeable chunk of the FTSE, are faring better than they have in the past. Oil has surged from $30 a barrel in 2016 to more than $80 today meaning companies like BP and Shell, two of the largest contributors to yield in the sector, do not have to sell assets, cut investment or raise debt to maintain the dividend.
Ford says: “These companies by and large held their dividends through the difficult times of 2015 and 2016 and now show signs of building cover as earnings grow.”
However, dividend cover is less than ideal at 1.25x for BP and 1.45x for Shell.
Causton says weak sterling has given a bit of a boost to the UK index but the main contributors to growth have been miners, particularly a “renewed” Glencore, and banks.
INCOME OUTSIDE THE UK
Investors don’t have to limit themselves to the UK for income, says Spencer.
He says Japan has strong dividend growth potential.
“While Japan has seen a marked pick up in dividend growth and share buy-backs over the past few years, compared to other developed markets, it still has a long way to go.
“The ability is there with Japanese companies having high cash levels on balances sheets and the will of company management is slowly but steadily changing.”
