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Dividend test

The equity income area of the market is drawing investor interest but questions remain over just how much dividends can prop up total returns and whether the payouts from UK companies can be sustained in a worsening economic environment.

Dividends are expected to take up an increasing portion of total returns – and not just in the income sector but also across most equity portfolios. But will the capital losses and the fear of continued falls outstrip the attractions of the high yields on offer from some funds?

Within the UK equity income sector, ahead of its forthcoming split, with some forced into the new income & growth sector for failing to meet income requirements, just 11 out of 99 funds are yielding less than 5 per cent, according to Trustnet figures. Yet over 2008, the median fund in this sector fell by more than 28 per cent, S&P Fund Services reported in its analysis of the sector.

Total return figures show that across the entire UK equity income sector, not a single fund has posted a gain over the three years, one-year and six-month periods ending March 19. The lowest fall over the three-year timeframe is 7.7 per cent achieved by Trojan income, with the next three portfolios in the top five all being managed by Neil Woodford.

Income managers are all promoting the high dividend streams available in their products relative to the growth available in gilts and cash deposit products but at least gilts and bank accounts are not losing money.

A 6 per cent yield on a falling capital base may not look that attractive until the markets start to move forward.

Speaking at the recent Cofunds round table on income, Newton head of European equities Raj Shant said: “Proper long-term income investors can afford to be patient through what is undoubtedly a difficult market and they are investing for income rather than capital growth at the moment.”

Trojan income portfolio fund manager Francis Brooke says: “If you can be confident of the income stream, you have to accept capital volatility at this time. Investors may suffer short-term capital losses but overall total returns will be fine.”

Fund managers in the equity income space are of the belief that dividends will not be cut massively in many companies despite the shaky econ omic outlook for the UK. Overall, the sustainability of dividends in the UK market remains in doubt.

Certainly, those companies paying out high levels, such as 6 per cent, are among those considered to be unsustainable. But what does that do to the overall picture for UK dividends and income?

According to the latest Barclays gilt and equity study towards the end of 2008, the five-year average growth rate for dividends had slipped to 7.8 per cent as companies began cutting payouts. Earlier this month, Investec Securities noted in a “prospects for income” report that while the consensus suggests the FTSE all-share will yield 5.3 per cent this year and 5.6 per cent next, to them it seems “highly improbable.”

The analysts believe the market will yield 4.4 per cent this year and a similar level next, meaning the total income payment for the FTSE 100 would fall from £55.5bn in 2007 to £44.2bn by 2010, a 20.3 per cent drop.

The rationale behind the Investec Securities argument centres on the elimination of banks from paying dividends as well as weakness in other sectors, previously known for sustaining shareholder payouts. In 2007, the analysts pointed out that banks accounted for a quarter of the total FTSE income, with oil supplying a further 16.6 per cent of dividends.

The top 10 dividend payers in the FTSE 100 accounted for 58.2 per cent of the whole index and four of that 10 were banks, with a further two oil companies.

Looking ahead, the analysts said, the question will be which sectors will replace those banks as top payers? “The impact of the decline in banking income will be to increase the relative importance of oil and mining to income investors and also the traditional consumer staples and pharmaceuticals sectors,” the Investec report reads. “We believe income funds will increasingly question the sustainability of income from mining, oil, fixed line telecoms and life sectors together with the traditional cyclical in capital goods and consumer-related companies. We suspect the income sustainability theme has further to run as some of these more speculatively yielding sectors continue to be questioned by investors.”

In its report on the UK equity income sector, S&P noted managers in this space are positioning defensively and many are introducing bonds to make up the income shortfall from banks.

S&P Fund Services associate director of fund research Alison Cratchley says: “Several managers comment that the income requirement is a challenge. Some are introducing an exposure to bonds. Michael Gifford, who manages the S&P A-rated Old Mutual equity income fund, has introduced a 5 per cent exposure to fixed interest, partly on the view bonds will be defensive in an equity market decline but also because they will make up the income shortfall left by the banks. He has raised the fixed interest component of the similarly rated Old Mutual extra income fund in the UK equity & bond sector for the same reasons.”

But Cratchley commented that other managers are finding sufficient opportunities in equities, with some pointing out that the weakness in sterling has helped to boost payouts from companies which declare their dividends in US dollars.

There is no doubt that available yields from UK stocks are high but they are also more scarce and sustainability is going to be a determining factor for income fund performance in the months ahead. Key to fund selection for intermediaries will be the assessment of the sustainability of income and a manager’s ability to find it in such a changing market.

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