- Company dividends are under pressure, with positive currency effects fading and dividend cover falling
- There is dividend growth to be found, but investors will need to look a little harder
- The investment trust structure allows investment managers to address a number of these problems
Those seeking an income from their investments have had little choice but to turn to the stock market in recent years as the interest on savings accounts and bonds has dwindled. Company dividends have offered a compelling mix of an income that grows over time – increasingly important in a reflationary environment – plus greater opportunity for capital gains. Nevertheless, equity income funds remain an imperfect solution.
While UK dividends appeared to end 2016 with a grand hurrah, up 11.7% in the last three months of the year alone, the lion’s share of this (£4,8bn of £5.2bn) came from the pound’s weakness (1.). Without the fall in the pound, dividends would have been just 0.6% higher.
Special dividends added another £3.3bn to the total. Without these or the changes in currency, dividends were 3.7% lower year on year. In other words, dividend growth has been patchy, reliant on currency and one-off dividends, rather than being supported by improving profits from companies.
This is not to say that there aren’t plenty of opportunities to find companies growing their payouts, it’s just that investors aren’t going to find them accidentally. In particular, payouts from FTSE 100 companies have been conspicuously weak: 2016 marked the third consecutive year that the UK’s largest companies have seen slower growth than their mid-250 peers. Top 100 dividends rose just 2.2% in 2016 in spite of the hefty boost from the weak pound, while mid-caps rose 5.0%, riding higher on stronger profit growth.
The point is also illustrated by the gap between cyclical and defensive sectors. The weakness of certain, previously reliable, defensive sectors has been a feature of 2016 – tobacco payouts were down 4%, for example, aerospace and defence down 17%, food and drug retailers down 22%. This may continue in 2017, with dividend cuts from Rolls Royce and Rio Tinto yet to wash through the figures.
This is not to make a point, necessarily, about large cap versus mid cap or cyclical versus defensive, but simply to show that an equity strategy of itself is not enough to ensure a stable and growing income. Trying to generate an income from an undifferentiated basket of income stocks is unlikely to offer the protection or the consistency that investors need.
Another problem is dividend cover. At almost 3.5% (2.), the yield from the FTSE All Share appears attractive, but dividend cover – the extent to which a company’s dividends is covered by profits – is falling. It currently sits at around 1x for the FTSE All Share as a whole, down 10% on a year ago and half its level of two years ago. This suggests the overall level of dividends in the market could come under pressure.
To our mind, investment trusts provide a solution to some of these problems: They have a fixed pool of capital, which means they don’t have to buy and sell holdings to meet investor inflows and outflows (as is the case for open-ended funds). This means that they can be more active than open-ended funds: Investment trust managers can invest as and when they see compelling opportunities, for both income and growth. Importantly, they are not dependent on larger companies with less stable, weaker-growing dividends to provide liquidity and/or income in difficult periods.
Investment trusts have the ability to reserve income in ‘feast’ years, to pay out in ‘famine’ years. This also affords investment trust managers more flexibility. It means they are not condemned to invest in the highest yielding companies, regardless of their growth prospects simply to support the annual dividend payout.
We would also argue that they compare favourably to enhanced income funds, which have been considered a solution to some of the difficulties of paying a high dividend yield for investors. These funds sell options on existing holdings to boost the income. The problem is that it limits the potential growth and a recent Hargreaves Lansdown report (3.) found that the higher income has in some cases come at the cost of capital growth, with some funds even experiencing capital losses.
Investment trusts can employ option writing to boost the overall income yield, but they have alternatives, such as leverage, to sustain a higher income. This allows for a more nuanced approach to generating income. Options can be employed when pricing looks attractive, but there is no necessity to write options if it doesn’t.
Investment trusts may not be a perfect solution to the income dilemma and, of course, investors must still be selective, but they have some natural advantages. Certainly, many of them have been delivering a stable and growing income for decades. As such, we believe they are a less imperfect option.
- Source: Capita Dividend Monitor – http://www.capitaassetservices.com/sites/default/files/SS15723%20Dividend%20Monitor%20Jan%202017-v6.pdf
- Source: Morningstar, 10th April
- Source: HL UK Equity Income Report, March 2017
- Bloomberg, 10th April
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