UK equities
10 Jul 2017 | By Ed Meier

Shopping around

Shopping for anything that is in short supply is frustrating. In the world of savings, where interest rates are at record lows, trying to pick up dividend income is no easy task.

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Shopping for anything that is in short supply is frustrating. In the world of savings, where interest rates are at record lows, trying to pick up dividend income is no easy task. Prior to the global financial crisis (GFC), UK government bonds typically offered investors a yield of ~5%. That same yield today is just 1%[1]. The reason for the difference is down to efforts from central bankers to stimulate economic growth. As part of their extensive bond-buying programmes, bond prices notched up impressive gains while yields fell (bond yields move inversely to prices). In today’s world, investors are left with just 30% of stocks currently paying an income greater than the current 3.8%[2]yield on the FTSE All-Share index. That’s what is sometimes known in the trade as concentration risk. You might want to consider extending the shopping list.

Looking for sustainable income

And shop around for income we must. Especially when cash yields nothing and the pitfalls of inflation are taken into account. So, where can we find these companies? In essence, we look for corporations that can hold on to their pricing power, something crucial for a company’s profit margin, profitability and healthy cashflow (in essence, the degree of cash a company generates). For us, the main areas on our list are utilities, mining companies, housebuilders and the still unloved banks.

Regulated utilities

While their business profiles are typically deemed unexciting, financial returns from regulated utilities offer protection from inflation. Water companies, United Utilities and South West Water, have linked both prices and dividends to the Retail Price Index until 2020, allowing shareholders greater income visibility. Additionally, South West Water’s waste management business, Viridor, centres on contracts with municipalities which afford a good degree of pricing power.

Healthy dividends from mining companies

Mining companies also typically offer good dividend growth. Having reduced their huge debt mountains, the result of highly-priced acquisitions made just prior to the crisis, they are now, on the whole, in rude health. Recent profits announcements from the likes of Rio Tinto and Glencore have confirmed that capital expenditure bills (the amount a company spends on plant and machinery) are low. This together with a ‘once bitten, twice shy’ mentality regarding any future purchases, frees up cash for shareholder dividends.

Profiting from cheaper landbanks – UK housebuilders

Land prices are crucial for the profitability of housebuilders – obviously one of their key expenditures.  Since the GFC, the demand/supply balance in land has been more controlled due to better quality players Taylor Wimpey, Barratt Developments and others dominating the market, while an inability to obtain credit has fortunately resulted in dwindling numbers of their ‘upstart’ counterparts. Decent mortgage availability, government schemes and a reasonably healthy UK economy have all helped support housing demand, leading to strong profitability and improved dividends.

And finally…the banks

It’s still a sector everyone loves to hate. But, since the crisis, banks are better regulated today than they have been for years. Capital buffers (in other words, ample levels of capital that, should a market-moving event such as the GFC happen again, they can withstand a crisis) have been vigorously tested while capital raisings have left them in a good place to grow their dividends. HSBC, Lloyds and Barclays, as a result of being in sound financial health, can, we believe, offer attractive and sustainable dividends.

As the die-hard shoppers amongst us will testify, we all love a bargain. Something we can typically find that is of reasonably quality but, for whatever reason, appears underpriced. As income hunters we, too, will always look for those dividends which, we believe, can comfortably surprise on the upside. Income may be harder to find amongst today’s dividend-payers… the trick, as ever, is in knowing where to shop.

 

[1]Source: Bloomberg as at 14 June 2017.

[2]Source: Bloomberg as at 06 June 2017.

 

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