In the UK, the contribution of reinvested dividends to total return is over 60%, highlighting how pivotal a role dividends play in total shareholder returns.
Total return in equities is evidently a mix of both capital growth and income, and investors can choose to get more from income and less from capital growth, or vice versa. The traditionally held view is the former approach is lower risk as income is deemed to be more of a certainty.
The foundations of this long-held opinion are therefore shaken to their core when a major income constituent such as BP disappoints – as it has unavoidably done in the wake of the Deepwater Horizon disaster – however the basic premise remains sound.
Hence, the mainstay of many income portfolios following this debacle is likely to be large-cap, high-yielding companies. The key from an investor’s point of view is to identify whether these yields are justified by the business as it stands in today’s challenging economic backdrop, rather than being a continuation of previous management decisions decreed when times were not so tough.
The reality for income seekers in the UK Equity Income sector is that plenty of opportunities remain. That said, investors need to differentiate between businesses yielding a decent amount at the same time as growing their capital from those who may be yielding a reasonable dividend to the detriment of the stability of their business.
The latter should be avoided unless the investor is prepared to take a risk, as a lack of strong, sustainable underlying business will inevitably impact the yield while the company continues to pay a large dividend simply because they always have, rather than it being in the best interest of the company.
Investors should seek out solid companies with the ability to demonstrate they can comfortably afford to pay their dividends in addition to generating value for their shareholders. Amidst a difficult economic environment, it is important to look at companies who can sustainably grow their business as well as generate an attractive income – the challenge is to create income while also protecting capital.
Some investors in the UK Equity Income sector could be accused of relying too heavily on a handful of key stocks for yield in recent times, a strategy that can quickly be flattened when the likes of BP unexpectedly fails.
Where investors may be uncomfortable with adjusting the shape of their portfolio in response, it is all to easy to revert into equally high-yielding stocks, which may not necessarily be able to offer good, solid total returns. Investors can therefore find themselves chasing yield for yield’s sake.
Instead, investors should look to capture income elsewhere by looking at strong companies who can also demonstrate clear evidence of sustainable growth – albeit perhaps offering a lower starting yield – that remains consistent with their strategic thinking, rather than simply being ostensibly lowly rated. When these very companies exhibit short-term periods of share price weakness, investors should look to buy.
To give some recent examples, Tesco, Pearson and Standard Chartered are three such companies. Tesco has suffered from concerns over consumer confidence in the UK and the impact of falling food price inflation at a time of industry space growth. However, we believe in Tesco’s case, food price inflation has not disappeared (given it is typically driven by the strong demands in emerging market consumption) and the group has the optionality to redirect expansionary capex to other parts of its business to sustain dividend growth if the returns available from the UK become unattractive.
In the case of education and publishing group Pearson, the market is particularly concerned about the potential impact of US state budget cuts. Pearson continues to take market share in the US schools education market, however, while diversifying revenue streams both by geography, as evidenced by recent moves in international markets such as Brazil and into more of the education value chain.
The sale of subsidiary IDC has given it significant balance sheet strength, both in terms of paying its dividends and growth for the future.
Standard Chartered shares had drifted back in recent months over concerns of the impact of slowing Chinese economic growth, but it remains in our opinion a very strong franchise, which is well capitalised with little regulatory risk and a reliable for growing dividend yield.
Returning to the BP shares, they have of course fallen quite some way over the last few months and are no longer paying a dividend. One option for shareholders doubly impacted by the dividend cut and falling share price has been to perhaps consider BP bonds as a short-term solution, as these were yielding around 7%, while holding on to the equity shares until such times as the price recovers.
In this sense, investors have the potential to catch some capital upside in addition to continuing to receive an attractive level of income.
As and when BP comes through this crisis, it will be interesting to see what view they take on the correct level of dividend distribution for the business. Will they establish a more sensible starting yield, or revert to paying out in line with their previous strategy?
That previous strategy arguably compromised its ability to create shareholder value by tying it to production growth rather than optimising the value of its assets. Perhaps the group may in fact consider that now is a suitable point in time to reassess its entire strategy, following the seismic shock it has suffered this year, offering a far lower yielding investment which is driven more by a desire to deliver capital appreciation.
It is entirely possible that such a bleak episode in the company’s history could in fact be turned into a positive future chapter for shareholders, deeming their shares a more attractive long-term total return asset in the future.
This is but one example of how investors must be flexible enough to recognise and accept that in today’s volatile world, the sources of investment return can often be somewhat different to their initial expectations. Overall though, reliable dividend income provides a sound, attractive and growing bedrock on which to base our total return expectations.
Phil Doel is manager of the F&C UK Equity Income fund
