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Where are UK equity income returns coming from?

cholwill

Whether it is concern over the state of bond markets or an increase in investor optimism in the latter part of 2012 but equity income returned to favour in the final months of last year.

Figures from the Investment Management Association show UK equity income was the best-selling sector in November, part of a general trend which saw equities overtake fixed income in the last four months of 2012.

IMA Chief Executive Daniel Godfrey said: “Fixed income funds attracted most retail money in 2012, the fifth consecutive year in which fixed income funds outsold equity funds. However, there was a clear shift in investor behaviour towards the end of 2012 with equity funds taking more money than fixed income funds every month from September to December.”

The IMA’s figures are backed up by recent figures from Fidelity Wealth which sampled the investment intentions of its clients in December. According to the firm, of those who are looking at investing in the coming months the most popular sector is equity income, the choice of 42 per cent, with 30 per cent opting for equity growth funds.

Fidelity Wealth head Chris Davies says: “The preference towards equity income may make sense for investors who are cautious but still want some growth. Historically, income has formed a significant part of total returns over the long-term. With some blue-chip shares paying dividends representing a yield of 5 per cent or more, small falls in share prices can still result in a positive total return.”

Royal London UK Equity Income fund manager Martin Cholwill says: “Given my central viewpoint that we will continue to see dividend growth over the course of the next 12 months, the UK equity market yield of around 3.5 per cent remains an attractive proposition in a world in which interest rates are expected to stay close to zero for a number of years.”

In 2012, the UK equity income sector returned 13.2 per cent. This compared well to strategic bonds and corporate bonds, which returned 12.4 per cent and 12.3 per cent respectively, but is substantially behind UK smaller companies and European smaller companies which returned 22.6 per cent and 22.5 per cent respectively.

A good portion of the investment return has been driven by general stockmarket returns, the FTSE 100 finished 2012 up by 5.8 per cent but the last 12 months has also seen a strong increase in dividends,

The latest Dividend Monitor from Capita Registrars shows that UK dividends totalled £80.4bn in 2012, an increase of £11.2bn on the previous year. A large part of the increase was due to the large amount of special dividends paid. In 2012, UK companies paid out £6.8bn in special dividends, more than in the previous four years combined.

However, Capita reports that the strong growth in dividends was starting to slow by the fourth quarter of the year.

The report says the general outlook for dividends is good but 2013 is likely to see the same level of growth.

The report says: “Investment is likely to remain relatively subdued, meaning that cash is available for distribution. Balance sheets are very healthy, and firms might justifiably be anxious to pay this money to investors, rather than risk the envious glances of the tax man.

“In addition, equity investors will continue to exert significant pressure on company managements to encourage them to continue paying out large dividends, as they struggle to find income from other sources. Nevertheless, Q4 seems to be raising warning signs that rapid growth in dividends may have come to an end. It is not possible for dividend growth to outstrip profit growth indefinitely, and eventually firms will have to use cash to invest again, or find themselves unable to grow. It seems likely that investors should expect slower progress from here.”

Capita is predicting that total dividends paid in 2013 will be equal to last year’s £80.4bn with the growth of regular dividends offset by a large reduction in the expected level of special dividends.

However, despite the surge in investor demand for dividend yielding equities, Fundsmith founder Terry Smith cautions against using dividends alone as an investment criteria.

Smith says: “Investing in the highest dividend yielding companies in the market can deprive investors of the potential to compound the value of their capital. We know of virtually no business that can grow without reinvestment. It is important to us that the companies in our portfolio reinvest at least a portion of their cash flow back into the business to grow. Over time, this should compound shareholders’ wealth by generating more than a pound of stock-market value for each pound invested. On the other hand, investing in high dividend yield companies risks the likelihood that the company is over-distributing (paying out most or all of their earnings as dividends) and cannot reinvest to compound value.”

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