Rathbone Income expects dividend growth next year

Several large UK companies had been paying out an excessively large portion of their profits as dividends for some time, which in some cases was at the expense of investing in future growth. And this is where the opportunity lies, says Carl Stick, who has managed Rathbone Income Fund (GB00BHCQNL68) for the past two decades. The pandemic is giving many companies an opportunity to reset investor expectations, which will make future payouts more sustainable.

“Although the feeling might be very negative around dividends in the UK, the reality is that we are in much ruder health now than we were because some of those difficult decisions have been forced on businesses,” says Mr Stick, who believes that the fund’s portfolio of 41 companies still represents an attractive income story. This is despite his expectation that the fund's annual distribution will be 20.5 per cent lower than last year. "It’s unfortunate, but it’s happened now and we have to get on with it,” he says. 

And the fund still had a 12-month yield of 5.31 per cent as of 21 September, which is very attractive relative to cash and lower-risk bonds.

Mr Stick expects to grow the dividend again from next year, and over the past six months has been surprised by the number of the fund’s holdings that have said they will pay a dividend, and/or pay interim dividends that had been deferred. However, investors should consider the potential for further lockdowns and a no-deal Brexit to present more challenges to UK companies. 

Crisis changes

Earlier this year Mr Stick sold Restaurant Group (RTN) and Carnival (CCL) as he did not want to own companies that had a chance of going bust. He also reluctantly sold engineering company Senior (SNR), which plays a significant role in supply chains for commercial aircraft. He says: “I still think it is a good business, but the industry is in a terrible state and I didn’t want to take the risk [of continuing to own it]”.

He has also been gradually reducing some large holdings that have been resilient since the the start of the coronavirus outbreak due to their valuations, for example Unilever (ULVR), Reckitt Benckiser (RB.) and GlaxoSmithKline (GSK). He has reallocated the proceeds to more early-cycle businesses. 

One of the most successful purchases the fund has made this year has been BHP (BHP), which has benefited from the prices of commodities such as iron ore rising this year. Mr Stick says that he has gradually been building his position in the mining company since the start of the year.

The fund also built up a position in paper and packaging business Smurfitt Kappa (SKG) early in the year as part of its repositioning towards more cyclical names. More recently Mr Stick bought a small position in Ferguson (FERG), a distributor of plumbing and heating products formerly called Wolseley, and housebuilder Persimmon (PSN), which recently reinstated its dividend. “These are all examples of more cyclical and economically sensitive names,” says Mr Stick. 

He has also recently added NatWest (NWG) which, like other UK banks, doesn’t currently pay a dividend. But Mr Stick expects that it will resume doing this “if we keep our fingers crossed on the UK economy”. He felt it appropriate to build up a position in NatWest because it was “extraordinarily cheap. Notwithstanding Covid-19, furlough schemes, Brexit – all the reasons why people don’t like UK financials – trading on 0.4 times net tangible assets with a balance sheet that is probably robust enough to withstand anything thrown at it, we felt that was a sensible risk to take." 

Mr Stick started moving away from so-called 'quality' at the start of the year because these types of stocks would rise and fall together. And although inflation doesn't feel like an immediate threat, if inflationary pressure starts to build up he wants to be in stocks that will benefit from that and massive stimulus injections into economies.

“It’s almost like it's perceived wisdom that we [will be] in a low rate, low inflation environment forever,” he says. "If that’s priced in, what happens if it changes?”

Opinions are divided on the possibility of a rise in inflation and it may seem a long way off, with reports that the Bank of England is considering negative interest rates. But Mr Stick notes how the narrative around inflation is changing with, for example, the US central bank – the Federal Reserve – saying it will allow inflation to go above its 2 per cent target. 

Rathbone Income also has positions in controversial sectors such as oil and tobacco. Mr Stick says the crisis has been the oil sector’s “come to Jesus” moment as they have been talking about participating in a “greener, cleaner future” for years and now are being forced to act. The fund owns Royal Dutch Shell (RDSB) and BP (BP.) which were forced to cut their dividends as the oil price plummeted following a spat between the Saudis and the Russians, and a sharp drop in demand. 

Mr Stick continues to own these companies because he believes that they are part of the clean energy solution despite them being unproven in this area. “Right now they are so disliked that it is sensible for us to have some money allocated to this area,” he explains. 

Tobacco companies British American Tobacco (BATS) and Altria (US:MO) are large positions in the fund as they have “safe secure” dividends. These have become the archetypal cash cow as they are generally able to increase the price of their product every year and pay out a large proportion of profits to shareholders. Mr Stick says that although holding tobacco companies doesn’t personally sit well with him, they serve a purpose for the equity income mandate and he cannot pre-suppose the views of his investors.   

The fund is well represented across sectors, with 24 per cent of its assets in consumer goods, 20 per cent in financials, 12 per cent in industrials and 10 per cent in healthcare at the end of August. Mr Stick says that he runs a balanced portfolio so performance “tends to be three steps forward, two steps back [as] we don’t plunge into one area or another”.

Taking the dividend cut opportunity

Mr Stick says that too many companies in the UK were paying out too much income and the crisis this year has provided a catalyst for them to rebase dividends and, in some cases, reallocate money to help the business grow. For example, Aviva (AV.), a small position in the fund, appointed a new chief executive officer in July, who has already made radical plans to slim down the business. Amanda Blanc has identified the UK, Ireland and Canada as core business areas and aired her intention to sell non-core business operations at the right price. Mr Stick says that she slashed Aviva's dividend and while her changes have been radical it has been the right thing to do. 

The coronavirus pandemic has thrown up opportunities for other companies the fund holds. Distribution company Bunzl (BNZL) suspended its dividend as demand dried up among retail customers such Costa Coffee. However, Bunzl also supplies the health industry and was able to reallocate money into growing areas. Its half year report, which was published last month, was far better than the market was expecting and Bunzl reinstated its dividend. 

The company has a record of making acquisitions and, due to the tough business environment, Mr Stick thinks that it may have an opportunity to buy more businesses at a very good price in strong areas, or distressed businesses in weaker areas that it thinks will recover.