The UK equity market has been a happy hunting ground for income investors over the past decade, with returns far outstripping those from cash. The first quarter of this year suggests a record pay out by UK companies in 2017, excluding special dividends. The FTSE 100 is forecast to yield 4% in 2017, 16 times greater than the current UK base rate. However, there are concerns surrounding the state of the market, as dividends become increasingly concentrated in specific stocks and sectors.
Rising risk in the UK
The recent increase in pay-outs has been buoyed by a range of external factors. These include the resumption of pay-outs by companies in the extractive sector, the current buoyancy of the banking sector and the sharp fall in Sterling post-EU referendum, which has been a tailwind for UK large-cap companies that earn much of their revenues overseas.
Despite the attractive top-line growth figures, investors should be cautious as there are several inherent risks within the UK equity income market. The market remains highly concentrated at both a company and sector level. The top five dividend payers were responsible for nearly 40% of the total dividend paid in 2016 and this rises to nearly 60% for the top 15 payers. Royal Dutch Shell alone accounts for almost 15% of the total figure.
Similarly, four sectors – Financials, Oil & Gas, Consumer Goods and Consumer Service – account for nearly 70% of UK dividends. This concentration increases the risks to income investors: when sectors have come under pressure in recent years, investors have been forced to turn to lower yielding areas of the market.
This risk has become more acute as the ability of companies to pay their dividends comes into question. The table above shows the dividend cover for the ten highest-yielding stocks in the FTSE 100. While the headline average yield remains at 6.6%, several companies have a cover level less than one – BP, Royal Dutch Shell, Vodafone and Admiral. For Royal Dutch Shell and BP the unpredictable oil price will be a key factor in their ability to pay the current 7% yield.
With these risks increasing, investors should look to diversification to offer protection against this. By looking further afield for dividend income, they can achieve dividend growth with reduced prospective risk.
Big opportunities in the US
The US remains the largest global distributor, accounting for over 40% of the dividend pot. In contrast, the second largest payer at country level, the UK, makes up less than 10%. The tax domestic regime on dividend income coupled with a preference for share buybacks by management has coloured the view on the US for income investors. However, despite higher valuations, several sectors offer attractive dividend income. While Technology companies often provide little for income investors, more mature businesses like Intel and Cisco offer 3% yields sourced from strong balance sheets. Meanwhile, Telecoms and Pharmaceuticals companies offer reliable dividends in sustainable businesses.
Diverging opportunities in Europe
In Europe, a core set of countries continues to dominate an anaemic periphery that is still suffering from the financial crisis. Three countries – France, Germany and Switzerland – account for nearly 60% of the total dividends paid in continental Europe. France, which remains the largest payer, and the Netherlands offer 12% and 19% dividend growth respectively. The recent recovery in the European economy should support sustainable and growing dividends.
Increasingly attractive Asia
The Asia ex Japan region offers the second highest level of dividend yield globally after the UK. Hong Kong and Australia continue to dominate, although the latter has suffered with a sharp decline in the commodity sector. However, South Korea and Taiwan both had a record year for dividend payments in 2016. The Taiwanese market offers a yield over 3.5%, which compares favourably to the 4% offered by FTSE 100.
In 2016, the headline rate in Japan increased by 24%. Increasing emphasis on corporate governance and transparency in Japan should drive this trend further. The newly established JPX-Nikkei 400 index requires companies to deliver more to shareholders via enhanced returns on equity and dividend payments. Meanwhile, Prime Minister Shinzo Abe’s reforms should encourage additional improvements. The 2020 Olympics in Tokyo could provide an economic boost following years of economic malaise, particularly in Abe’s key areas – infrastructure development and promoting tourism.
The hunt for global yield: Growth and diversification
While, the UK will continue to remain a core market for income investors, the growing risks to UK pay-outs mean it is prudent to diversify exposure. Although all equity markets have inherent concentration risk at sector and company level, adding global names to an income portfolio should provide that diversification and some income growth. By carefully selecting opportunities in the US, Europe and Asia, investors should find companies with attractive balance sheets, dominant market positions and sustainable, growing dividends.
Ketan Patel, fund manager at EdenTree Investment Management