Join our community of smart investors

Why you need to look further for income

UK yields may be high, but overseas equities offer better income over the long term
April 27, 2017

The UK market continues to offer some of the best equity yields available, with the FTSE 100 forecast to yield 4 per cent in 2017. However, it is also highly concentrated, meaning that a few expensive companies - some of which have seen income flattered by weak sterling - account for a large part of the total dividend haul.

The Capita UK Dividend Monitor reports that although UK dividends in the first quarter (Q1) of 2017 totalled £15.4bn, 9.5 per cent higher than those paid out in Q1 2016, one company alone - BHP Billiton (BLT) - was responsible for 3.5 per cent of the headline growth rate. Meanwhile, just four sectors are forecast to contribute 67 per cent of FTSE 100 dividends in 2017, with oils, banks and insurance contributing 46 per cent of this, according to broker AJ Bell.

And since the UK's vote to leave the European Union last year, the weak pound has been artificially flattering UK dividends. Although in Q1 2017 headline dividends were 9.5 per cent higher than in the same period last year and underlying dividends excluding special dividends were 16.2 per cent higher, when the impact of weak sterling is stripped out underlying dividends actually fell. The top 100 companies' payout over the first quarter was 16.8 per cent greater than what they paid during that period in 2016, but 90 per cent of that increase was due to exchange rates. If the pound strengthens that would bring an end to the "sugar rush of currency gains".

Some UK companies are also paying out more in dividends than they are taking home, meaning their scope to grow payouts is looking stretched, according to AJ Bell. Four of the top-10-yielding companies in the FTSE 100 are not expected to earn enough in the coming year to cover their forecast dividends, and the 25 companies yielding the most in the FTSE 100 have dividend cover of less than 1.5. Unless profits soar among those companies, their ability to maintain or increase their payouts looks vulnerable.

 

Dividend cover for the 10 highest-yielding FTSE 100 stocks in 2017

StockForecast dividend yield in 2017 Forecast dividend cover in 2017
Direct Line7.5%1.09x
Royal Dutch Shell7.1%0.96x
Barratt Developments7%1.47x
Taylor Wimpey7%1.39x
BP6.8%0.91x
SSE6.3%1.31x
Legal and General6.1%1.43x
Vodafone6%0.52x
HSBC6%1.28x
Admiral Group5.9%0.95x
Average6.6%1.13x

Source: AJ Bell, 10 April 2017. Top 10 highest-yielding FTSE 100 stocks by forecast yield

 

Looking beyond the UK

So if you haven't already, it might be worth diversifying your income allocation with some overseas equity exposure.

"You can understand why UK equity income funds are so popular because of the high yield on the UK market, but concentration risk is very high and has been for some time," says Jason Hollands, managing director at Tilney Group. "Around 40 per cent of the [UK market's] total yield pot comes from the five largest stocks and Royal Dutch Shell (RDSA) alone accounted for almost 15 per cent of the UK's entire dividend pot in 2016."

 

Popular shares in UK equity income funds

ShareHow many times appears in top 10 holdings of 10 largest UK equity income fundsAverage weight in funds (%) PE ratio**
Royal Dutch Shell85.4644.88
GlaxoSmithKline84.9784.59
BP75.151,395.90
AstraZeneca74.7921.16
Imperial Brands64.5256.79

Source: Nutmeg, as at 20.04.17. *How many times stock appears in top 10 equity income fund (by assets under management) top 10 holdings. **Thomson Reuters

 

A global equity income fund is a good route to easy diversification and, although its yield may be lower than that of the FTSE 100, its income may be more sustainable.

"If you only hold UK equity income funds and want to diversify towards international investments, the ideal starting point is a global equity income fund," says Rob Morgan, pensions and investments analyst at Charles Stanley. "With one of these funds you will have a manager ideally cherry-picking the best opportunities from around the world. There is a natural instinct for investors to look just at the headline yield of a company or fund, but usually in the longer term you get a better total return by accepting a lower yield that will grow over time."

Fidelity Global Dividend (GB00B7778087), for example, prizes long-term sustainable income over short-term yield, and the fund yields 2.9 per cent. Its manager, Dan Roberts, is willing to sacrifice some yield to invest in high-quality companies he believes will be able to grow their payouts over time. In 2015 this enabled him to increase this fund's dividend when over 50 per cent of IA Global Equity Income funds cut theirs.

Fidelity Global Dividend holds around 50 stocks, including familiar names such as British American Tobacco (BATS) alongside less obvious income generators such as Japan-listed Bridgestone (JP:5108), which have lower yields but greater potential for income growth.

This fund is the second-best performer over five years in its sector, after Artemis Global Income (GB00B5N99561). This fund does not stick closely to a benchmark, as its manager, Jacob de Tusch-Lec, avoids popular and expensive income stocks in favour of less well-known value-focused names. He derives income from three types of stock: those with low, but secure, yields; those more likely to cut their dividends at certain points in the business cycle; and companies with high but potentially insecure dividends.

"If you want something rock solid you will end up paying 25 times earnings for it, so we try to hold things where the dividend feels fairly secure and then hold other companies where we know it's likely that if the cycle turns they might cut their dividend," says Mr De Tusch-Lec.

So he invests in US banks instead of consumer staples stocks and holds Italian telecoms and TV tower companies Infrastructure Wireless Italiane SpA (INW:MIL), Rai Way (RWAY:MIL) and EI Towers (EIT:MIL), whose share prices are suffering because investors fear that Italy could pull out of the euro.

"We have three Italian stocks in our top 10 and it does give you some sleepless nights," explains Mr De Tusch-Lec. "But it's all about having a view on something that's different to the rest of the market and getting it right."

Darius McDermott, managing director of Chelsea Financial Services, likes M&G Global Dividend (GB00B39R2R32). This fund sits in the IA Global sector and aims to deliver a dividend yield above that of MSCI All Country World index. Its manager, Stuart Rhodes, has no target income requirement and aims to invest in companies that are likely to increase their income over time. The fund yields 2.9 per cent and is overweight basic materials, financials and consumer cyclicals stocks, which was detrimental to its performance between 2014 and 2015, but benefited it when those sectors returned to fashion in 2016.

 

Go to Asia for the long term

Companies across Asia have steadily been increasing the dividends they pay out to investors and there is more scope here for dividend growth over time than in the UK market. It also has the benefit of cheaper share prices combined with chunky yields.

"The standout area for income right now is Asia," says Mr Morgan. "Asian markets had a tough time in recent years, but in the past 18 months have rallied hard. However, I still think there is value to be had, and companies have started paying out quite attractive levels of dividends. You can fairly easily get a yield of 3 per cent from an Asian income fund. The beauty of these funds is that you get a big range of different sectors and exposure to technology, which is an under-represented sector in UK equity income funds. You not only get good growth prospects, but also nice yields, which are hard to find in UK technology stocks as these tend to be smaller growth-orientated companies."

Asian equity income fund options include Schroder Asian Income (GB00B559X853), which invests in 60-80 stocks and yields 3.6 per cent. Its largest holdings include Taiwan Semiconductor Manufacturing (2330:TAI), HSBC Holdings (5:HK), China Petroleum & Chemical Corp (600028:SHH) and China Mobile (941:HKG). Over five years this fund has returned 75 per cent against the IA Asia Pacific ex Japan sector average of 57.5 per cent. Its manager, Richard Sennitt, has more than 20 years' experience of Asian equity investing and has managed this fund since 2001.

Schroder Oriental Income Fund (SOI) is run by well-regarded manager Matthew Dobbs and yields 3.7 per cent. Over 10 years this investment trust has returned 215.4 per cent, compared with 130.9 per cent for MSCI Asia Pacific ex Japan index. The trust includes exposure to Australia and New Zealand, and is run with a strong value discipline.

Aberdeen Asian Income Fund (AAIF) yields 4.5 per cent, but its performance has been more volatile. Over 10 years it has returned 177.1 per cent, but the share price fell 9.2 per cent in 2013 and 16.8 per cent in 2015. The trust aims to invest in defensive, quality businesses, so this performance raises some questions.

 

Add Japan for growth

Japan is not associated with income investing, but companies here offer the best opportunities for long-term dividend growth at the lowest price. Japanese companies have built up a reputation for hoarding cash on their balance sheets rather than paying it out to shareholders, but a push by Prime Minister Shinzo Abe, combined with pressure from international investors, is changing this.

In 2015, dividends in Japan increased at a greater pace than those in the US, UK and European markets, and payout ratios have been increasing.

"Yields at around 2.1 per cent are low compared with some other markets, although similar to the US, where companies tend to prefer share buybacks to paying dividends, and Japan has the highest percentage of companies with net cash on their balance sheets of any major market," says Mr Hollands. "But that means they have a lot of scope to increase payout ratios, which are currently the lowest of any market. Payout ratios in Japan stand at 35 per cent, compared with 55 per cent in the US and around 90 per cent in the UK."

The payout ratio in Japan used to be about 20 per cent.

"The dividend growth potential of Japan is perhaps the number one positive income story," continues Mr Hollands. "Japan has many great companies, such as Sony (6758:TYO) and Nintendo (7974:TYO), and the universe of companies paying dividends has steadily built up.

Japanese stocks remain among the cheapest, despite earnings growth of more than 5 per cent in the past two years - greater than Europe, emerging markets or Asia Pacific ex Japan.

Mr Hollands highlights CC Japan Income & Growth Trust (CCJI), which yields 2.4 per cent. This investment trust underperformed the Topix index in 2016, but has outperformed it so far in 2017. Holdings in the trust include Bridgestone, TechnoPro Holdings (6028:TYO) and Japan Tobacco (2914:TYO). The trust has a high-conviction portfolio of 20-40 names, and its managers look for companies with a strong and sustainable cash flow and shareholder-friendly returns.

Jupiter Japan Income (GB00B6QC0Z69) yields 2.15 per cent and has beaten the IA Japan sector average and Topix index over three years with a total return of 70 per cent. The fund has one-third of its assets invested in consumer cyclical stocks and has 42 holdings, including Toyota (6201:TYO), KDDI Corp (9433:TYO) and Bridgestone.

JOHCM Japan Dividend Growth (IE00BKS8NS44) yields 1.6 per cent and invests in 36 companies, including Canon (7751:TYO) and Toyota. Its largest sector allocation is also consumer cyclicals.

 

Fund performance and yield (cumulative total return %)

FundYield (%)*6m1yr3yr5yr10yr
GLOBAL EQUITY INCOME       
M&G Global Dividend2.713.9127.2238.2278.33
Artemis Global Income 2.94.8424.4348.37118.56
Fidelity Global Dividend 2.91.5517.9855.58107.37
MSCI World index4.3024.7553.66100.70125.16
IA Global Equity Income sector average 2.693.2919.1536.2774.1394.59
ASIAN INCOME        
Schroder Asian Income3.592.1326.9546.0574.96190.24
Schroder Oriental Income 3.673.7628.3552.5478.92215.44
Aberdeen Asian Income 4.543.225.9121.1136.09177.05
MSCI Asia Pacific ex Japan index-2.629.2842.4559.44130.87
IA Asia ex Japan sector average 1.152.1528.7343.657.48128.6
JAPAN       
CC Japan Income & Growth Trust 2.43.7617.55---
JOHCM Japan Dividend Growth 3.063.0523.2154.83--
Jupiter Japan Income 2.15-2.3618.0670.05--
TSE Topix index-0.1422.8667.0491.7481.99
IA Japan sector average 0.46-0.0222.7962.0486.5172.17
IA UK Equity Income sector average 4.07

Source: FE Analytics, as at 24.04.17 *Morningstar