Fund managers reveal telecoms, housebuilders and retail as some of the sectors they believe will be able to continue their strong run in 2016, alongside the trouble spots.
David Smith, UK equity fund manager, Henderson Global Investors
I bought Victrex and Big Yellow on increased dividend expectations. Victrex manufactures high performance plastics for industrial and medical applications and now the company has completed its production facility upgrade, this frees up cashflow to return to shareholders via special dividends.
Big Yellow is the UK's leading self-storage company with exposure to London and the South East. With space at a premium in the capital, self-storage demand is set to grow rapidly as the population expands. This structural growth, along with the company adding further sites, will drive strong earnings and dividend growth over the medium term.
Meanwhile, despite Lloyds recently increasing its dividend, the outlook for the rest of the UK banking sector is more difficult. RBS and Standard Chartered are unlikely to pay a dividend for the foreseeable future, while HSBC will find it tough to grow divis given cost concerns.
Tineke Frikkee, manager, Smith & Williamson UK Equity Income fund
Stocks bucking the dividend slowdown fall into two groups: stocks with strong growth in income and stable income. In both categories, we focus on profitable companies with strong balance sheets and stable or growing demand from customers.
Within the fund, examples of growth income stocks are Howden Joinery; it has grown its dividend by 17%. Housebuilder Bovis has also raised its dividend by over 20%.
I believe income portfolios should contain stable income stocks; here BAT and Pennon benefit from good earnings visibility. We should be careful with those engineering and support services companies where weak end demand means falling sales.
Manufacturing companies have a lot of fixed costs combined with fixed-rate debt, so profits and balance sheet strength can decline quickly. I believe this is likely to reduce their ability to pay dividends.
Stephen Message, manager, Old Mutual UK Equity Income fund
Lloyds & BT
One investment which is bucking the dividend slowdown trend is Lloyds Banking Group. Having returned to the dividend register in 2015 after more than six years absence, the recent announcement of a 1.5p final, and a 0.5p special dividend was well received.
We take this as a clear signal the company is comfortable with its capital position, which was also backed up by the recent passing of bank stress tests.
Elsewhere, BT Group has delivered above average rates of dividend growth, which we believe will be supported in the future as it increases its offering beyond fixed line services to include mobile, sports content and high speed broadband.
We have less exposure to a number of 'bond proxy' investments, where we do not consider the combination of yield and potential dividend growth to be attractive relative to the broader market.
We do not currently own Reckitt Benckiser, Diageo, Unilever or National Grid.
Iain Wells, co-manager, Kames UK Equity Income fund
Dividend fears have been concentrated around a small number of stocks and a smaller number of sectors: mining, oil and gas, and the odd contractor. Beyond this the picture is less negative.
Housebuilders have rewarded investors with strong dividend growth and clear medium-term cash return plans. Numerous companies in a diverse range of sectors have declared special dividends including retailer Dunelm, insurers Beazley, and chemicals company Croda.
Sensible places offering reasonable, and secure yield in the year ahead include: retailers like M&S, transport stocks such as Go- Ahead, and tobacco. Life insurers are a little controversial right now but yields are high, and dividends look secure and likely to grow.
The areas to avoid are where the current yield does not appear to compensate for the earnings risk. This would still include miners and oil and gas stocks. Without a recovery in their underlying markets, questions about sustainability will only increase.
Mike Fox, head of sustainable investment, RLAM
Dividends are a health check on the long-term prospects of a company, which is why investors pay so much attention to them, and why companies only cut them when no other option is available. A dividend cut is a sign of a strategy gone wrong, or an industry whose prospects have fundamentally darkened.
The UK market can be divided fairly clearly into three areas: cutters, maybes, and certainties. The cutters are mining companies, where China has stopped buying their end product in such vast quantities.
The maybes, which have high income yields but may need to cut them, are companies such as BP, Shell, HSBC and GlaxoSmithKline. Each needs an uptick in fortunes to justify their payouts.
The certainties are those companies with essential products and services, the demand for which is growing, such as BT, Unilever, National Grid and Severn Trent.
Thomas Buckingham, portfolio manager, JPM UK Higher Income fund
History shows dividend yields, growth, and reinvestment drive stockmarket returns over the long term.
Commodities-exposed stocks have been hurt by the fall in oil prices and slowdown in China, leaving many of these companies looking like yield traps in our view. With this in mind, our investment process has identified more attractive opportunities in more domestically-focused areas.
The consumer sector is benefitting; more cash in the pockets of individual consumers increases their discretionary spending, a factor which is driven by low petrol prices on the back of lower oil.
These factors act as a tax cut for consumers and therefore benefit dividend-paying consumer discretionary companies and general retailers. For example, retail names such as Debenhams look attractive with a near 5% dividend yield, while many companies in the telecommunications space, such as Orange and Proximus, also boast attractive dividends.
We are also finding attractive dividend yields in the UK housebuilders sector. With the average production of UK homes at less than 20,000 per year over the last two decades, and household population growth exceeding 50,000 per year, there is a clear supply and demand misbalance, and exposure to UK housebuilders continues to look attractive.
Blake Hutchins, manager, Investec UK Equity Income fund
Focus on 'capital light' sectors
We look for companies whose business models allow them to generate high and growing levels of cashflow, year-in year-out, enabling the payment of a sustainable and growing dividend. We firmly believe dividends must be paid out of the cashflow statement, and not the balance sheet.
Capital intensive sectors such as utilities and energy with optically high dividend yields are, we believe, paying unsustainable dividends since they are not supported by cashflow.
Not only are they unlikely to be able to cover their dividends with current cashflow, but in order for these businesses to stand still let alone grow in the long term, requires huge amounts of capital expenditure. Be that to build new power stations, dig new mines or drill for oil.
This results in poor cash generation and often growing debt levels, which is unsupportive of a growing dividend.
Our focus is on the sectors and companies whose business models are of such strength that even after having invested fully back into their businesses for future growth, they can generate enough cashflow to reward shareholders with growing dividends.
Capital light sectors such as consumer staples, software, healthcare and selective other financials are well placed.
Michael Clark, portfolio manager, Fidelity MoneyBuilder Dividend fund
Sectors I would highlight would be pharmaceuticals, fixed-line telecoms, consumer goods and regulated utilities. There is particularly good visibility of returns in the regulated utilities such as the water and electricity companies, given parameters are set for the companies in a five-year regulatory cycle. Severn Trent, a regulated utility company, is a good example.
Consumer goods companies with strong brands, such as Reckitt Benckiser, are also among those I favour. Although the headline P/E looks high, the company has consistently grown in a low growth world and is very cash generative with a high return on equity.
I remain cautious on the oil and gas majors as dividends that looked challenged at $70-$80 oil, are seriously under threat at an oil price of $30. As a result, where I have exposure to the sector it is at a level well below the index weight and only in names where there have been reassurances over the near-term dividend payments.
Robert Smithson, partner and fund manager, THS Partners
Dividends are the lifeblood of investment, channelling businesses' profits back to their investors. But not all dividend payers are created equally: some firms have too much debt or are in cyclical industries where profits can evaporate.
Among the safest dividend payers should be the consumer goods companies – such as Unilever and Nestlé – where emerging market growth will continue for decades.
We believe banks are in better shape than many realise. A combination of higher capital buffers, and conservative lending over the past five years, means many firms should be able to continue paying out, even during a downturn.
The global oil majors – such as Shell and BP – are also in better shape than many realise; these firms have little debt and should be able to cut capital expenditure dramatically. We are more cautious on smaller energy companies, miners, and oil and gas services companies.
Nick Clay, manager, Newton Global Income fund
Value in markets still remains in those businesses where returns are strongly protected against low growth and deflationary forces; businesses that are stable and not cyclical, balance sheets are not over-levered and whose management demonstrate good capital allocation.
In a world of negative bond yields, we believe those companies that pay a sustainable income will be highly sort after. As a result, we continue to like the defensive sectors of tobacco, staples, utilities, and healthcare.
We are generally avoiding banks, miners, oil, emerging markets and cyclicals. Emerging market debt (EMD) is a sector we have been wary of for a while. Of the trillions of dollars recently invested in EMD, around 80% of the flows have come from ETFs, which is predominantly retail money.
In previous crises when companies' borrowing costs have increased and they could not afford to service them, they would go to the bank (their lender) and in many cases the debt would be restructured.
Against a backdrop of slowing Chinese growth impacting local revenues and a strong US dollar inflating the debt, problems are likely to arise.
Stephen Bailey, co-manager, Liontrust Macro UK Growth & Liontrust Macro Equity Income
While the defensive characteristics of telecoms should not be a surprise, we think the sector's ability to generate recurring revenues and sustainable dividends is still underappreciated at current valuations, which are at a discount to the market. We own BT, Vodafone, AT&T and Verizon.
The investment credentials of tobacco are gradually eroding, so investors would do well to consider telecoms the heir to the title of equity income addiction sector – the beneficiaries of dependence on mobile data consumption.
To illustrate the contrast in prospects, consider that while British American Tobacco estimated an industry decline of 2.3% in 2015, Cisco reported global mobile data traffic grew by 74% over the year.
Income investors should also be wary of excitement surrounding dividend revival at the incumbent UK banks. The operational and regulatory headwinds that this sector still faces are apparent through the need for further balance sheet provisions and are not conducive to the kind of earnings stability that should underpin an income investment.
Kirill Pyshkin, portfolio manager, Mirabaud Global Equity High Income fund
One place dividends are broadly increasing is Japan. There are several reasons for this but most important are the new corporate governance code with more focus on shareholder returns, excess cash on the balance sheets of Japanese companies that pressures ROE (another focus for the code) and low dividend payouts of around 30% (versus almost 70% in the UK).
Take Nissan, with a 30% dividend payout. Its automotive segment has ¥1.4trn net cash or 30% of the market cap. Hence, Nissan has just announced another measure to boost shareholder returns this year in the form of a new share buyback, to add to its dividend which has already gone up by over 25% this year. The two measures together mean all of its profits this year will be returned to shareholders.
Quite understandably, comparing the payouts and looking for the potential for growth of dividends, we are overweight Japan and underweight UK in our global equity high income fund relative to the MSCI World.
But this is an unusual stance in comparison with our peers, where many have huge UK exposure and rarely look at Japan.
Garry White, chief investment commentator, Charles Stanley
Companies that generate a lot of hard cash are the ones that are best able to pay dividends. At the moment, the housebuilding sector continues to throw off cash.
The housebuilders have changed their business model to operate with low levels of debt, build for margin not volume, and distribute excess cash. After many years of under-production, the housing market has a structural supply deficit.
Meanwhile, the larger companies are able to buy land at attractive prices. Persimmon recently said it would increase the amount it returned to shareholders after a solid 2015. It now plans a dividend of 110p a share on 1 April, significantly higher than the provisionally planned payment of 10p a share.
These dividend trends are to be found across the sector, but this positive outlook for dividends is not widespread across the market and some could be at risk.
Aberdeen Asset Management, for example, has seen eleven-consecutive quarters of net cash outflows. As a consequence it is yielding 8%, which is clearly distressed. Smaller peer Ashmore's yield, at 7.2%, also could be at risk.
Nathan Sweeney, senior investment manager, Architas
Value in miners
Given the current low growth environment, company management are very aware of the premium investors put on dividend payment, so much so, that even mining companies are succumbing in a bid to win over investors.
We have seen some stark reactions in the share price of Lloyds and RBS over the last week, as Lloyds increased its dividends while RBS cut. This highlights the importance of being selective.
Given the low rate environment, banks' profits are likely to become more pedestrian or utility like, thus increasing the importance of dividend payments.
One area that investors have been avoiding is mining and oil companies. However, the yields on offer in those sectors are quite compelling, if the companies can maintain these payments given a reduction in profitability. The long-term focused investor may see this as an opportunity.
It is also worth noting these companies are performing very well year to date.
Geir Lode, head of global equities, Hermes IM
In this low-yield environment, high-dividend stocks look attractive to many investors, but this is often an illusion. We believe there are two main risks that investors need to be wary of: a company's inability to sustain the dividend, and an increase in interest rates, which would make a high dividend less attractive in general.
We analysed the MSCI World benchmark by sector, looking at prospective dividend yield, and found investors are expecting a 10% cut in the energy and materials sectors in 2016. This view is too bullish – we expect to see dividends drop much faster. We have already seen industry leaders like BHP Billiton cut dividends by 74%.
We also expect dividend cuts in the financial sector: banks are facing tougher capital requirements and credit losses from the energy sector, which contradicts expectations of a higher dividend.
So investors beware: dividend cuts are coming and stocks do not react well when it happens. A selective approach is required. High dividend stocks need sound fundamentals like free cashflow and balance sheets, which are more likely to generate greater shareholder returns over the next two years.
Cole Smead, managing director, Smead Capital Management
I like to refer to certain stocks as members of the 'dividend buyer's club'. Miners used to be part of this club, due to their hefty dividends and a former un-ending belief in the success of commodities. They are no longer members of the club today.
We believe banks like Bank of America, J.P. Morgan and Wells Fargo will become the consuls of this club over the next ten years. Retirees will flock to the dividend payments made by these companies as the fears of the future become the belief in the US economy of tomorrow.
Consumer staple stocks will fall from the leadership in the dividend buyer's club as lofty valuations and disappointing dividend growth, in a strong dollar era, sadden club-goers.
Capital intensive businesses (telcos and utilities) could also disappoint the clubbers as the cost of capital rises in the good old USA.
Philip Gorham, senior equity analyst, Morningstar
Tobacco fundamentals strong
Consumer staples firms have historically been fairly defensive during economic slowdowns, and we expect the same to be true this time around. Although real wage growth will act as a constraint to organic growth, the steep fall in the oil price should relieve some of the pressure, particularly for low income consumers.
Within the global consumer staples space, we expect tobacco manufacturers to deliver particularly solid dividends. Industry fundamentals are as strong as they have been in years, with Europe rebounding, pricing power intact, and tighter control over national borders leading to a fall in illicit trade.
urrency movements are the industry's major headwind at present, but that is unlikely to stop the big manufacturers such as British American, Imperial Tobacco and Philip Morris International from delivering mid single digit dividend growth for the forseeable future.
Ross Hollyman, fund manager, Sabre Fund Managers
Look to overseas markets
Let us start with stocks to avoid. From the perspective of most people reading this, it is a very easy answer: anything in the UK. This is NOT because the outlook for UK stocks is necessarily worse than that for those listed overseas.
Unfortunately, however, if you are a UK income investor, the likelihood for any given UK idea is you already own too much of it. The UK Equity Income gene pool is very limited, and is the preferred habitat of many talented stock pickers, so new and different ideas are unlikely to emanate from this source. Instead, we look to overseas markets.
Paul Weyers, fund manager and investment analyst, Brown Shipley
Global macro trends are bearing down on a significant proportion of the UK equity market in 2016, which is likely to lead to a tougher dividend environment. The collapse in commodity prices has hit mining stocks especially hard, with 2017 dividends expected to be barely a fifth of their 2014 peak. Conversely, these macro drivers have provided good support for other sectors of the market.
As an example, easyJet (and the likes of easyJet) stand out as a beneficiary of the weak oil price and its investment in capacity should enable it to grow its dividend. More generally, the low inflation, sustained low interest rate environment, while not especially supportive for banks, should continue to support consumer-spending growth, benefiting consumer facing stocks and staples such as Unilever.
We believe companies who are in an investment and growth phase, an example being Spire Healthcare have long-term dividend potential as they mature.
James Hackman, manager, Neptune US Income fund
Look to IT sector
As someone investing in the US, I could just say invest in the US and avoid the UK. However, digging down to a stock level, the information technology sector looks to be the area to buck the trend and the area to avoid is oil & gas.
Chevron, the US oil major, has grown its dividend at 8.3% on a five-year basis, 5.9% on a three-year basis but it is flat on a one- year basis with the last dividend increase in early 2014. Low oil means low dividend growth.
Texas Instruments, the semiconductor designer and manufacturer, has increased its quarterly dividend at a double digit growth rate over the last one, three and five years. Management are focused on cashflow per share and return capital to shareholders in the form of a growing dividend.
John Innes, portfolio manager, UK Focus fund
DFS and Crest Nicholson
It is well known that dividends are an important component of long-term returns from equities. Given the generationally low levels of bond and cash yields, dividends can also provide a premium level of income. On the other hand, the underlying stocks have to be chosen with care.
There are a number of companies such as the mining companies that have been radically cutting their dividends, so any company with excess debt and declining earnings is to be avoided to reduce the chances of disappointment.
There are a number of companies, however, that are continuing to increase their dividends on the back of growing underlying cashflow such as DFS and Crest Nicholson.
There are also those companies, such as Lloyds Bank and Intermediate Capital Group, that are increasing their dividends after a number of years accumulating excess capital that can now be released. Capital strength and robust earnings are the key criteria for income generation and resilience.
Keith Ashworth-Lord, fund manager, UK Buffettology fund
Focus on asset-light businesses
Dividends are paid out of cashflow, not accounting earnings. Cashflow and earnings can differ markedly, so selecting companies that always convert a high proportion of their earnings into free cash is one filter mechanism.
Businesses that consistently earn a high return on their invested capital are prima facie examples of enduring franchises. These can exert pricing power and avoid the worst of pressure on their earnings.
As well as seeking predictability and certainty, you should avoid businesses that are highly operationally geared with large ongoing requirements for capital expenditure to maintain their operations. It is often the case that asset-light businesses have the best cash generating shape.
These businesses frequently sport strong balance sheets providing management is sensible as to how it allocates capital. The best are those can reinvest capital at attractive rates and if not, return it to shareholders. The worst are the empire builders relying on acquisitions.
Scott McKenzie, managers, Saracen UK Income fund
These are hazardous times for income investors in the UK. Scarcely a day goes by without a dividend cut being announced and we expect dividend growth from the UK equity market to be close to zero in 2016, despite the strength of the US dollar boosting translated dollar dividends.
The dividend cuts in the mining sector have now happened. The banking sector is moving further into focus with a cut now announced by Barclays. However, many financial sector companies are in good health.
Lloyds, Jupiter and Intermediate Capital have all announced special dividends recently while life companies such as Standard Life and Aviva continue to deliver good dividend growth.
Looking further afield, we are of the view that many small and mid-cap companies continue to offer far better dividend prospects across a wide range of sectors. If one moves away from the woes of the Goliaths, then there are many Davids capable of positive dividend surprises.
Adam Avigdori, co-manager, BlackRock UK Income fund
Banks have proven to be an emotive topic since the financial crisis. The government bailouts, subsequent heavy regulation and the fines that followed have hung over the sector for the last eight years. However, we believe this sector has found its feet again, with calls on profits waning, capital ratios fully rebuilt and regulatory pressures stabilising.
Underlying retail and commercial banking profits at UK banks such as Lloyds are robust and we are increasingly see these profits distributed as dividends. At a time when market commentary has focused on the high profile dividend cuts in the commodity sector, the banks sector is offering a timely reminder that companies, such as Lloyds, are growing their dividends.
Matthew Page, co-manager, Guinness Global Equity Income fund
Whenever we look for a company that offers an attractive dividend, the size of the dividend yield itself is the last thing we look at. History shows us that companies that generate persistently high return on capital over a business cycle are often able to pay a sustainable and potentially growing dividend. Cisco is a company that meets these criteria and recently increased their dividend by 25%.
Perhaps the worst combination for an unsustainable dividend is low return on capital, high leverage, and weak pricing power. These companies often manage to sustain and perhaps even grow their dividends in easy economic conditions but are highly prone to external shocks.
Low return on capital means cash flow is weak. High leverage means cash will often need to be diverted to reduce debt at the expense of the dividend. A lack of pricing power means the dividend may never recover and you could suffer a permanent impairment of capital.
Today, the pool of developed market stocks with a dividend yield over 4% is dominated by this second group of companies with almost half of this group being made up of the most economically sensitive industry financials.
Douglas Lawson, director and fund manager, Amati Global Investors
Manx Telecom is bucking the dividend slowdown. In 2016, the consensus expectation is that the dividend will grow by 7% to 14.4p, representing a yield of 6.8%. The Manx business model lends itself well to a healthy dividend payout. The company has a strong position as the Isle of Man's primary provider of broadband, fixed line and mobile telecommunications.
These services provide a high degree of revenue visibility and customers tend to be 'sticky', due to a combination of reduced provider choice relative to mainland UK and the high levels of service that Manx provides.
More recently, Manx has begun developing its own estate of data centres and now has two Tier 3 facilities, with tenants including the Isle of Man government and Paysafe, an online payment processing company. This is a higher growth area of the business, which should help to support future dividend increases.
Chris White, manager, Premier Asset Management
Companies with strong balance sheets, steady earnings and a dividend payout that is covered by both profits and cash flow, such as BAE Systems, should be able to buck the dividend slowdown.
Despite slowing global growth, the UK consumer should continue to spend their windfall from low petrol and food prices, and companies such as M&S and Greene King look well placed to benefit and grow their earnings and dividends this year. Two-fifths of UK dividends are paid in US dollars, so sterling's recent weakness looks set to provide a strong tailwind to payouts in 2016.
Royal Dutch Shell and BP may be at risk of a dividend cut in 2017 if the price of oil fails to recover by early next year, but the risk is reflected by their 8% dividend yields.
The sustainability of GSK's dividend is a concern. After three consecutive years of earnings decline, the pressure is on for GSK to return to growth. Last year it paid a dividend totally uncovered by free cashflow which is rapidly weakening the balance sheet.
Roberto Magnatantini, fund manager, Oyster Global High Dividend fund
The latest rounds of dividend cuts are a fresh reminder that sustainability is a key parameter to assess when in the hunt for yield, as in the long run dividends have to be paid out of free cashflows.
Oil companies today, as European telecoms a few years ago, are facing a dilemma: what to do when your profitability plummets but your shareholders are addicted to your stock's yield? Tricks like scrip dividends or debt issuance can plug a hole in the short term, but in the end companies will have to adopt a credible strategy and bite the bullet if their dividend has become unsustainable.
Statoil is a good recent example, as it coupled a scrip alternative to its dividend cash payment whilst also reducing its capex plan as part of this balancing act. The positive market reaction to the announcement was probably a good indication that the market is ready to hear about sensible cuts.
Trevor Green, head of UK equities and manager of UK Opportunities fund, Aviva Investors
Prospects for divi payers are getting better
Despite the difficulties afflicting traditional dividend payers such as miners, there are better prospects for dividend increases among a number of companies with conservative payout ratios.
Despite the adverse headlines, balance sheets in the UK corporate sector in general are healthy and not all of the cash that companies generate will be spent on M&A, particularly given the fragile global macroeconomic backdrop.
Companies such as ITV, UDG Healthcare and easyJet, which enjoy individual growth drivers, have the potential to increase their payout ratios or pay special dividends. Indeed, ITV has just paid a special dividend of £400m. The dividend sends a clear message on management's confidence in the company's outlook and its cash-generation capabilities.
ITV is benefiting from the strength of consumer spending, which is boosting advertising revenue. But it enjoys a further boost to growth via sales of content around the world. It is buying content providers, which tend to be scarce; a strategy that is not only boosting and diversifying revenues but reducing the business' vulnerability to any downturn in advertising.
The miners Anglo American and Glencore suspended dividend payments in 2015, and others could follow. Declining oil prices are also hurting some energy dividend-paying heavyweights.
Royal Dutch Shell has not cut its dividend since 1945, and will strive to avoid doing so. However, its current forecasts are based on a crude oil price of $60 a barrel in 2017, and it may be forced to re-examine its dividend policy.
BP is in a slightly better financial position, but will not cover its dividend from internally-generated cashflows until 2017 at the earliest.
The major supermarket operators have also been good dividend payers. But they face intense competitive pressures due to the rise of discounters such as Aldi and Lidl, and the growth of online sales.
Tesco, Sainsbury's and Morrisons have already all cut their dividend by over 50 per cent and will come under further pressure following the introduction of the new National Living Wage in April. The same is true of low-margin, labour-intensive support services such as manned security providers and low-margin clothing retailers.
Months of negotiations
PARTNER INSIGHT: Ian Lance and Nick Purves, managers of the TM RWC UK Equity Income Fund, analyse the tug of war between value and growth that is being observed in markets today and why the future for value investing looks bright.
PARTNER INSIGHT: Ian Lance and Nick Purves, portfolio manager of the TM RWC UK Equity Income Fund, discuss the opportunity shift from growth to value after ten years of underperformance.
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