Are UK dividends in danger?

Dividends have long been a significant feature of the UK stock market, historically accounting for the major share of the total return from equities. Indeed, since 1986, when the FTSE All Share Index started, a £100 invested would have be worth £512.34 today on a capital return basis but with dividends reinvested the total return would be £1,476.49 (data at 30/9/14)*. To illustrate the stature of the UK market as a leader in dividend generation, HSBC Global Research estimates that in the year to May, UK listed companies paid out £75 bn in dividends, dwarfing distributions from companies listed in many other major economies such as Japan (£48bn), France (£39bn) and Germany (£29bn).

Yet as we pointed out in the last edition of our Premier Selection guide in August, the rate of dividend growth in the UK has become more sluggish this year. Since then, Tesco, the UK’s 15^th largest dividend distributor, has hit the headlines by slashing its dividend by 75% as it and other major supermarkets have reported stiffening competition from discounters Aldi and Lidl.

Concerns have also begun to foment about the tougher dividend outlook for other large FTSE 100 companies, such as the UK’s largest pharmaceutical firm GlaxoSmithKline, a longstanding popular holding in many equity income funds. GSK has recently issued a profits warning and announced plans to sell a portfolio of older drugs, which while seen as making strategic sense, will put pressure on near term profits. While most analysts believe GSK’s dividend won’t be cut, the level of dividend cover – the ratio of a company’s earnings per share over the dividends paid per share – has dropped to 1.2x. Unless earnings growth picks up at GSK, that is likely to restrain dividend growth.

A real challenge facing equity income investors is that the overall pool of dividends in the UK is dominated by a small cluster of major payers. In fact according to Capita, five large companies – Royal Dutch Shell, HSBC, Vodafone, BP and GlaxoSmithKline – are estimated to account for 36% of the total pool of UK dividends and the largest 15 dividend distributors represent 57% of all dividends. Yet many of these companies are in sectors facing headwinds on growth prospects. Big commodities companies are being impacted by softening demand from China as its economic growth rate slows, and weak oil prices coupled with rising extraction costs are a challenge for the UK’s major oil companies.

Could mid- and small cap income funds offer dividend growth potential?

While most traditional UK equity income funds typically invest at least two-thirds of their portfolios in large companies, there are a handful of funds that allocate more heavily into small and mid-cap companies. Although the overall yield on the FTSE Mid 250 Index of 2.9% and the FTSE Small Cap Index of 2.5% are lower than the FTSE 100 Index (3.5%), earnings growth is expected to be much higher in these parts of the stock market next year. That means greater potential for dividend increases.

Funds in our Premier Selection that are predominantly invested outside of the FTSE 100 Index are the four-star rated Standard Life Investments UK Equity Income Unconstrained fund, which is 48% invested in mid-caps and 14% in smaller companies, and the sister investment trust, Standard Life Equity Income PLC, run by the same manager, Thomas Moore.

For a greater focus on higher yielding smaller companies, the Unicorn UK Income fund derives 97% of its income outside of the FTSE 100, with 11% of the fund invested in the FTSE Mid 250, 50% in the FTSE Smaller Cap index and 23% in AIM. For investors with existing holdings in traditional larger company biased income funds, this fund could be used to provide income diversification. Instead of the usual line up of large pharmaceutical and oil company names, this fund’s top holdings include movie theatre chain Cineworld, pub company Marston’s and global construction and facilities management group Interserve.

Diversify overseas

As well as diversifying your sources of income into mid-sized and smaller UK companies, another way to achieve a broader spread of dividends is of course to look beyond the UK stock market. Among our most highly rated global equity income funds is the four-star Newton Global Higher Income fund which is approximately 44% invested in the USA, 35% invested in Europe and 14% in the UK. For more details on the funds, click on the fund name to read our research notes.