The UK remains one of the strongest equity income-paying markets in the world. It hosts a suite of multinational corporations with long records of paying steady and rising dividends. More and more these strategies are being rewarded by investors, in part because of the thirst for yield amid record low bond yields and interest rates, but also because of the tendency for dividends to signal quality to investors, in the shape of strong cash- ow, robust balance sheets and good corporate governance.
If a management is not spending money on important projects, it is returning cash to shareholders, signalling to the market its continuing confidence in the business’s success that will in turn bring fresh revenues for further projects. Against this, it can be true that companies awash with cash will eventually start to waste it.
But there’s a slight structural issue in the UK stock market: the top 20 companies hand out 70 per cent of all UK dividends paid; the top 10 pay 50 per cent; the top five pay 35 per cent.
Research by Henderson has delved deeper into this trend, analysing all of the UK equity income funds and investment trusts above £200 million to see who holds what and in what concentration. It found that 26 per cent of all of the money managed in the sector is invested in the 10 stocks in the box above. The chart below shows how many of the 52 funds and investment trusts we analysed held each of the top 10 stocks in their portfolios.
It reveals that on average, 70 per cent of the funds in the sector hold all of the top 10 stocks. is is actually unsurprising: as equity income portfolios get larger, fund managers are forced to hold the same few very large companies in order to receive enough dividends to pay all of their shareholders.
This trend towards dividend concentration is further evidenced by the fact that, among the largest equity portfolios in the UK, the average percentage held in these 10 stocks was 39 per cent. Certain fund managers have more than 50 per cent of their portfolio in them. When the liquidity pool is small, fund managers may simply have little choice.
The percentages shift around over time, but the analysis does raise the spectre of concentration risk. UK-based investors are likely to have the majority of their interests focused in Britain, including their job, houses, cars and investments. Yet when private investors look to diversify, they often forget the totality of their UK exposure.
Investors also often hold multiple funds to try to protect against any individual manager’s poor performance – but due to the income concentration they are likely to be unwittingly duplicating across many of the same stocks.
What happens when something goes unexpectedly and spectacularly wrong – often referred to as a black swan event? A good example is the Macondo oil spill in 2010, when BP was forced to cut its dividend amid the rising and uncertain cost of the disaster. As it was one of the top five dividend payers in the UK, this led to substantial shortfalls for equity income fund managers.
Henderson International Income Trust (HINT) was launched for exactly these reasons in 2011. It is mandated to invest globally in income-yielding equities, but importantly it excludes the UK entirely, offering investors the chance to diversify away from their UK-based investments and sources of income.
What is more, the income profiles of sectors differ across regions. Asia, for example, has higher-yielding businesses in areas such as technology and industrials, a contrast to western markets where these sectors tend to have very low yields. The upshot is that sector-level diversification is possible in addition to the geographic diversification.
HINT is an investment trust and we strongly believe this structure benefits investors seeking income; in any given year the fund manager is able to retain up to 15 per cent of dividends in a reserve pot, so that during difficult times when stock markets are down and perhaps dividends are being cut, the fund manager can use the reserve to top-up the income paid out to investors. The effect is to smooth the dividend payments over time, which may be useful to those who rely heavily on the income, for example retirees.
Record of rising dividends
Henderson runs some of the oldest investment trusts in the world, with some of the longest records of consecutively rising dividends for investors. Where relevant, the dedication to income objectives is driven by an independent board of directors that open-ended funds (Oeics and unit trusts) do not have.
Investment trusts are also able to gear – arranging borrowings, much like a mortgage for a house. Banks are able to lend to the investment trust through a mix of short-term and long-term loans, which the fund manager then invests, usually during times where there are plenty of opportunities in the market that the manager wants to capitalise on.
The jargon for this in the industry is a carry trade – trusts borrow at a certain rate, put that money to work in the market, and aim to earn a return higher than the cost of borrowing. The application of gearing exaggerates market movements, so the fund manager needs to employ the tactic skilfully as it will enhance losses in down-markets as well as gains in up-markets.
As far as the construction of the HINT portfolio is concerned, from time to time we will pick stocks within an overarching investment theme applied to the portfolio. Long-term structural growth trends, also known as secular growth, underpin these themes. Once a theme is identified, the team will look at the underlying stocks and choose investments with the potential for capital as well as income growth.
We base our investment decisions on a few factors: whether the companies generate a lot of cash in their normal operations and whether they encapsulate the three Us: companies that are undervalued and unloved by investors, and those with earnings under-appreciated by the market.
One recent example of an investment theme we like is data growth. Telecoms companies invested very heavily in network data licences at the end of the 1990s, to capitalise on what they thought was going be prodigious consumer demand for mobile internet and a considerable uplift in their earnings. But the tech didn’t meet the challenge, and the dream did not become a reality until 2007 and the invention of the smartphone by Apple. Alongside regulatory scrutiny of data charges, earnings underwhelmed and a period of poor performance bedded in.
However, we think the tide has turned, with easing regulatory pressures in the face of the need for infrastructure investment, and as consumer demand for data has exploded with better smartphones and faster processors. Companies we include in this theme are also geographically diverse, with investments in Israel (Bezeq), Portugal (NoS), France (Orange SA), US (Verizon), Hong Kong (HKT), Sweden (Telenor), South Korea (SK Telecom) and New Zealand (Spark).
Top 10 stocks
- Imperial Brands
- Royal Dutch Shell
- British American Tobacco
- HSBC Holdings
- Legal & General Group
- Vodafone Group