Dividend income –where to find it?

Equity income funds investing in the UK equity market are hugely reliant on the mega-caps to supply their income. The largest ten stocks account for around 50 per cent of the total income in the FTSE 350, which leaves the remaining income to be paid from 340 companies!

This concentration of income has been a source of criticism cast against the UK market and used as a reason to diversify to global equity income funds away from UK-only funds. For example, in Europe (excluding the UK) the top ten stocks account for around 23 per cent of the total income available.

We believe that equity income funds are a good place to invest given the current economic backdrop of low GDP growth, low returns on cash, low returns from bonds and high inflation. While still classed as a risk asset, the returns are much more bond-like than a broader basket of equities. In fact, on a risk-adjusted basis, you would require twice as much return from a basket of low-yielding equities than from a high-yielding basket to justify the extra risk.

While the UK market is dependent on the mega-caps for income, our estimates show that there is in fact more dividend growth available from outside the mega-caps. For 2011 we estimate dividend growth for the market of 15.9 per cent. We also estimate that the mega-caps have dividend growth of 16.7 per cent, but this is being skewed by the reintroduction of the BP dividend. If we exclude this, the dividend growth on the top nine falls to 7.05 per cent. We expect market dividend growth excluding BP of 11.4 per cent.

Reasons to be cheerful
In the UK, the recent interim reporting season gave us further fuel for bullishness. We recorded 200 equities announcing interim dividends in the reporting season. Of these, 78 per cent were dividend increases, 6 per cent were dividends cuts and 17 per cent were unchanged.

The majority of those that were cut were FX related, where the dividend was unchanged in US dollars but was down in pounds due to a weaker $/£ exchange rate. The unweighted simple average dividend growth was 19.5 per cent, but the growth rate of just those stocks that increased the dividend was 26.4 per cent.

In addition to this strong level of growth we still find ourselves in a situation where the payout ratio is way below the 30-year average and not far from the lows. Chart 3 shows the payout ratio from September 1981 to September 2011 along with the 30-year average for the UK. While this points us towards the possibility of future dividend growth, it also gives us downside protection that if earnings do come under pressure then the current dividend policies can easily be met.

Another reason to be bullish on dividends is the state of corporate balance sheets. In 2009, we witnessed mass debt-for-equity swaps through rights issues. As the credit crunch took hold, bank lending slowed and debt markets dried up, companies understandably panicked. Faced with a slowing top line, they decided to tap equity holders in the form of rights issues.

The net result is companies with lower gearing and greater free cash flow, as the interest payments and capital repayments are lower. We suggest that equity holders should demand a higher dividend return in lieu of rights issues they undertook in 2009 and seek cash returns as a form of coupon before companies waste it.

Investors have been buying corporate bonds as an alternative to equity income and they have had an incredible run, but now the underlying assets look less attractive at these levels. Many commentators would point to the bond yield vs the equity yield gap as a pointer that equities are cheap. While we would argue that in the short term we are happy that the equity yield is above the bond yield – we would pay more for security than prospects of growth – we believe that in the longer run we would demand a higher bond yield to make up for the lack of growth eroded by inflation.

Table 1 shows a list of investment-grade equities where the equity yield is a multiple of the bond yield. To be a holder of the bond at these levels we believe that the investor is implicitly saying that the company is not going bust and the cash flows are fine. If this is the case then we argue that investors should be buying the equity and not the bond. If the balance sheet and the cash flows are in trouble then we would argue that investors shouldn’t be paying such a high price for the bonds.

So while the mid-cap stocks are not providing the heavy lifting in terms of dividend income, they are in fact supplying the dividend growth to the market. While investors have been investing in corporate bond funds for income, the level of the underlying investment-grade assets now look less attractive and we would suggest that the equity looks much more attractive.

In a low-growth but high-inflation environment, dividend growth is going to be a crucial part of the total return from equities, while the income return will be a stable and ever-increasing element of the total return from equities.

Alex Stewart is an equity income strategist at Shore Capital.

Shore Capital is a financial services group that specialises in equity capital market activities, alternative asset management and principal finance. It has offices in Guernsey, London, Liverpool, Edinburgh and Berlin. Its equity capital markets division offers a wide range of services for companies, institutional investors and other sophisticated clients, including corporate finance, stockbroking and market-making. Its asset management division manages specialist funds, with a particular focus on real estate, growth capital and alternative asset classes. The group conducts principal finance activities using its own balance sheet.