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The search for dividend growth continues

UK companies’ dividends in the second quarter rose at their slowest pace in over three years, according to the recent Capita UK Dividend Monitor, leaving some questioning where to look for future growth.

Dividends climbed just 1.2 per cent year-on-year to reach £25.8bn after the FTSE’s 100 largest firms were hit by a strong pound and global economic turbulence.

Miners and financials were among the companies paying lower dividends because they are the most exposed to these headwinds. Sectors exposed to the recovering UK economy – such as travel and leisure, general retailers and housebuilders – lifted dividends.

Despite this, analysts point out that dividend growth is still healthy among the bulk of companies in the UK market. SPDR research shows “dividend aristocrats” – firms with a 10-year record of stable or increasing dividend payments – grew payouts by 10.8 per cent over the first half of 2014 compared with 5.4 per cent for the wider market.

Premier head of UK equities Chris White says most sectors continue to show “reasonable” dividend growth and this is expected to continue for some. “With a reasonable backdrop for the UK economy, companies focused on the domestic story can expect a helpful driver for earnings and dividend growth,” he says.

White’s £376m Premier Income fund holds double-glazing manufacturer Safestyle UK and convenience store McColls as plays on the domestic recovery.

Schroder UK Alpha Income manager Matt Hudson has been focused on dividend growth for the past 18 months, arguing the shift in the business cycle to the late-stage
expansionary phase is making sectors such as media, travel and leisure, non-bank financials and pharmaceuticals attractive.

“Those kinds of businesses are much more appropriate when you’re moving into the latter part of the cycle,” he says. “What they lack in the speed of their earnings recovery compared with cyclicals they make up for by having a more consistent earnings progression, which means you can get better dividend growth.”

Holdings of the £905.8m fund, which have potential for dividend growth, include media company Reed Elsevier, life insurer Legal & General and telecommunications
giant BT Group.

Old Mutual Global Investors’ Stephen Message highlights banking as a sector with potential for significant dividend growth because it is still recovering from the effects of the financial crisis. Message has about 10 per cent of his £128m Old Mutual UK Equity Income fund in banks, through holdings such as Lloyds Banking Group and HSBC.

“In the case of Lloyds, we’re not being paid a dividend yet but we think we will be by next year,” he says. “This will be off a low base but with meaningful scope for growth over the longer term. 

“One day, we think Lloyds will be a healthy payer of dividends again.”

Message also says the contrarian sector of mining is looking attractive for dividend growth – a point agreed by Psigma Income co-manager Eric Moore. Both the Old Mutual and Psigma funds have exposure to Rio Tinto and BHP Billiton.

Moore says: “While commodity prices will continue to be volatile, these companies are now diversified enough that they will be able to offer a relatively smooth dividend growth profile. Both Rio and BHP also operate at the bottom end of their cost curves and are well set to deliver high single-digit growth for the next few years.”

Two of income investors’ favourite areas – pharmaceuticals and tobacco – are still regarded as good for future dividend growth. Neil Woodford returned to the sectors with his recently launched £2.2bn CF Woodford Equity Income fund, taking big bets in names such as AstraZeneca, GlaxoSmithKline, British American Tobacco and Imperial Tobacco.

Premier’s White says: “If I had to pick one sector that always delivers for UK equity income investors and should continue to, it would be tobacco.”

He highlights the recent deal for Reynolds American to buy Lorillard as being beneficial for tobacco investors. BAT, which owns a 42 per cent stake in Reynolds, will fund part of the transaction, while rival Imperial will buy a portfolio of Reynolds and Lorillard brands to ease anti-trust concerns.

White says: “Imperial has told the market it is going to grow its dividend by 10 per cent a year over the next two to three years. BAT will also be able to grow its dividend although not to match the 10 per cent expected from Imperial.”

Moore says the prospect of dividend growth within the pharmaceuticals sector looks “very good”. Psigma Income is very overweight pharmaceuticals through holdings such as GlaxoSmithKline, AstraZeneca, Novartis and Roche.

“It may not be roaring away at double digits this year but those companies will be able to sustainably grow their dividend at high single digits for the foreseeable future,” he says.

“We’re entering a period of quite good growth for these companies. There are quite a lot of structural growth drivers: an ageing population, moves into emerging markets and the beginnings of a new generation of treatments for previously lethal conditions.”

Despite the positive outlook for some sectors, managers argue achieving strong dividend growth will be a challenge for UK companies. Most expect dividends to increase by around 5.5 per cent this year although they stress dividend growth prospects should not be sacrificed in the pursuit of high yields.

Hudson says: “It’s always a balancing act in an income portfolio between stocks that have a high yield now and stocks that are able to grow their dividend. 

At this point of the cycle, there’s more of a challenge to build a portfolio that captures elements of both premium yield and dividend growth.”

Dividends

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