Divi bonanza: How to pick the income winners

Fund managers in the UK equity income space have enjoyed a turnaround in fortunes over the past 12 months, following the Brexit vote.

Weak sterling helped UK companies with overseas earnings to produce record profits, which contributed to higher dividend distributions. During the second quarter, a bumper £33.3 billion was paid out in dividends, which represents a 15% increase compared to the same period in 2016.

Even stripping out the currency effect since last year’s Brexit vote, the underlying rate of growth was 8% – the fastest appreciation in two years. This was helped by £4.6 billion that was paid out in
special dividends.

Total dividend payments for the first half of the year stood at £48.7 billion, prompting Capita to predict that full-year payouts could reach £90.6 billion.

‘The gloves came off in the second quarter, as UK plc limbered up to deliver a knockout year in dividends,’ said Capita’s chief executive for shareholder solutions Justin Cooper. 

‘Shareholders can be thankful they had punchy special dividends and the weak pound in their corner, but improving profits have also played their part.’

Against this positive backdrop, where do the best income opportunities lie?

‘During the first half of the year, our top-performing dividend stocks were packaging company DS Smith and wealth manager St James’s Place, which both declared a 20% increase in their final dividend,’ said AA-rated Iain Wells, manager of the Kames UK Equity fund.

Wells expects life insurance stocks to perform well during the second half of 2017, highlighting the high yields on offer and dividend growth potential.

‘Expect volatility in share prices as credit worries ebb and flow. But thanks to their strong capital bases and seasoned management teams, we believe dividends are secure. For example Aviva with a 5% yield growing around 9% per annum, or Legal & General at nearly 6% yield, growing at 6% per annum.’

Other stocks favoured by Wells include Lloyds Bank, which has overtaken HSBC as the highest yielding bank at 5.9%.

Meanwhile, Wells believes Card Factory looks undervalued, given the company’s track record of returning cash to shareholders. He expects the yield on this stock to reach 8%.    

However, Aviva Investors UK Equity Income manager James Balfour is concerned that underlying dividend growth was largely delivered from a handful of companies during the first half of 2017.

He points out that more than £28 billion of UK dividends during the first half of 2017 came from six companies: HSBC, British American Tobacco, GlaxoSmithKline, AstraZeneca, Shell and BP.

‘All of which either have large US businesses or revenues that are stated in US dollars,’ he added.

However, not all businesses benefited from sterling weakness. One fund manager warns this trend could harm a number of income stocks over the long term.

‘Of the top 10 companies contributing to the UK’s total dividend payout in the second quarter, we have positions in Reckitt Benckiser, Diageo, GlaxoSmithKline, Royal Dutch Shell and BP,’ said AAA-rated Anthony Cross, co-manager on the Liontrust Special Situations fund.

 ‘However, for companies sterling weakness is a double-edged sword, negatively affecting those which need to import goods or services, but beneficial for those which export.’

In his opinion, the currency effect could provide a headwind further down the road.

Stocks to avoid

Neptune Income fund manager Robin Geffen (pictured) agrees. He expects to see weakness in the UK economy and sterling from here. As a result, he and deputy manager George Boyd Bowman are avoiding companies that rely on the strength of the UK economy or consumer. Instead, they favour companies with international earnings.

‘We simply don’t believe in this thesis that the housing market will ride on and housebuilders will churn out increasingly profitable new developments. Quite clearly – given the weakness in the housing market and the weakness in the economy – we think that is simply not a good place to be,’ Geffen added.

Over the last few months, the managers sold out of Talk Talk, WPP and Greene King.

They increased the £208 million fund’s technology exposure after buying Sage Group. Meanwhile, Glencore, Smiths Group and BAE Systems were added to the portfolio in recent months

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