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Searching smallers for reliable income

The outlook for FTSE 100 dividends is not good but you can find more reliable sources among small and mid-caps.
January 14, 2016

The UK market has traditionally been one of the best sources of equity income, the majority of which has come from large-caps. But following a number of high profile dividend cuts by larger companies during 2015 there are concerns this could continue or accelerate in 2016. Dividend cover on the FTSE 100 has fallen steadily since 2011 and is now at around 1x earnings, a level some say suggests dividend payments are becoming unsustainable.

While this does not bode well for UK equity income funds, Fraser Mackersie and Simon Moon, co-managers of Unicorn UK Income (GB00B00Z1R87), are not particularly concerned. This fund has around a third of its assets in mid-caps, 20 per cent in Alternative Investment Market (Aim) shares and most of the remainder in small-caps.

"The outlook for smaller, more domestically focused companies looks robust," explains Mr Mackersie. "Most of our holdings have clear, defined dividend policies - one of the things we look for when we initiate a new investment. We also put a tremendous amount of weight on dividend cover when selecting a stock.

Given increasing evidence of a return to sustainable revenue growth, generally strong balance sheets and improving cash flows, the expected growth in earnings should comfortably support current valuation levels [of small and mid-caps]. Many of our companies have a stated policy that a percentage of their earnings per share should be returned to shareholders, so earnings performance will flow through to dividends."

Mr Mackersie and Mr Moon like companies to generate cash, be well financed and have strong balance sheets, and they screen out non profitable ones as part of their investment selection process. They also rarely invest in a company without meeting the management, exceptions including the only three FTSE 100 shares the fund holds - BT (BT.A), easyJet (EZJ) and Old Mutual (OML).

Although they don't take huge bets on sectors and largely pick shares according to a company's individual merits, they do not have direct exposure to, and only limited indirect investment in, commodity related sectors which have been hit by weak prices. Oversupply and slowing demand for many basic commodities suggest another tough year for these.

"Commodity-based stocks are increasingly being forced to move from unrealistic, progressive dividend policies, towards a model that is based on paying out a defined proportion of their earnings," says Mr Moon. "This is likely to result in lower levels of absolute dividend payments, since depressed commodity prices will continue to drive earnings lower."

 

Fraser Mackersie and Simon Moon CV

Fraser Mackersie is co-manager of Unicorn UK Income Fund and lead manager of Unicorn UK Growth (GB0031217937). He has worked at Unicorn Asset Management since 2008 before which he spent two years at F&C Asset Management.

Mr Mackersie has a BSc (Hons) in Economics and Management from the University of St. Andrews, and is a Chartered Certified Accountant.

Simon Moon is co-manager of Unicorn UK Income and lead manager of Unicorn UK Smaller Companies (GB0031785065), and has worked at Unicorn Asset Management since 2008. Before this he worked for a year as a researcher at JM Finn & Co (Stockbrokers).

 

But they have been increasing Unicorn UK Income Fund's exposure to the domestic economy and the UK consumer over the past couple of years. "Disposable income should continue to improve as real wages increase, while other inflationary pressures remain benign, creating a strong environment for efficiently managed businesses that are exposed to discretionary consumer spend in the UK," says Mr Mackersie. "The UK consumer is in a strengthening position as a confluence of factors increase discretionary spending power including the falling price of oil and consumer staples."

Portfolio stocks providing exposure to the UK consumer include pub companies Marston's (MARS) and Greene King (GNK), Cineworld (CINE), and easyJet. The fund also holds shares not ranked in consumer sectors but which still provide exposure to the UK consumer, for example Secure Trust Bank (STB).

Greene King was one of four new positions they added to the fund late in 2015. "Greene King acquired a huge pub estate from Spirit Pub Company and the market has not appreciated the synergies that can be achieved," says Mr Mackersie. "These pubs are decently positioned and Greene King can bring them up to its standards. There was scepticism on whether the risk was priced in, but before Christmas progress was ahead of schedule."

Insurer Old Mutual was added as a value play because it is on a low price/earnings ratio (PE), has an attractive yield (currently 5.7 per cent) and its dividend is well covered. "The price was down because some investors were concerned about it being impacted by currency depreciation in South Africa," explains Mr Mackersie.

They added Victrex (VCT) because it has just finished a round of capital expenditure which frees up cash to return to shareholders, including via special dividends. It manufactures polymers for use in smartphones, oil and gas equipment, medical devices, aeroplanes and cars.

Its yield of 2.9 per cent is on the borderline lower limit of what they might consider. "But the company stated in its final results that it is looking to pay special dividends so this should increase significantly," adds Mr Mackersie. "And the company is a world leader in what it does."