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UK dividends: the reward for waiting?

Graham Smith

Graham Smith - Market Commentator

In the end, Thursday’s deadline for Britain leaving the EU passed peacefully for the prime minister, and markets too.

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Caught between the opposing forces of uneasiness about another Article 50 extension and forthcoming general election and a growing sense that parliament will eventually ratify a deal with the EU, the UK stock market now treads a delicate path between exasperation and hope.

Days when a resolution to the Brexit crisis has seemed more imminent have lifted domestically oriented stocks and the pound, but depressed the market’s big overseas earners. On other days, when a further, long drawn out period of uncertainty has seemed the more likely outcome, the opposite has often played out.

It may seem then that markets have been fairly reflecting the intense political and economic uncertainty that currently grips Britain. Since the end of March, the FTSE 100 Index has broadly gone nowhere¹.  

However, when you think about it, the market’s recent resilience could be viewed as quite impressive too. The Brexit impasse continued to depress business and consumer confidence over the summer, and economic growth has clearly slowed.  Given that the stock market normally tries to look ahead and discount events in advance, you might have expected a worse performance from what is, essentially, but a small corner – about 5.5% – of the world stock market².

The UK market does have at least a couple of important factors running in its favour though. First, valuations compared to those for the rest of the world have remained low.

The stocks that make up the MSCI United Kingdom Index trade on about 12 times the earnings those companies are expected to make over the next year, compared with about 16 times for world equities ³. That would seem to leave plenty of scope for the release of some latent value at some point.

Second, the UK’s peculiar characteristic of rewarding investors with generous dividend payments has come into sharper focus recently, because world growth has been slowing down and central banks have been cutting interest rates. With returns from cash frankly poor – both in absolute terms and compared with inflation – there has been good reason to seek refuge in dividend paying stocks. 

This week though, some ominous chickens came home to roost for several of the UK’s big dividend payers. First there was HSBC, which reported that challenging market conditions dented profits in the third quarter and has hastened its plans to restructure⁴. 

There were downbeat messages from BP and Shell too. Both said this week that a weaker oil price – owing to weaker world growth and ample supply conditions – ate into profits last quarter. 

GlaxoSmithKline lightened the mood, reporting growth across all three of its businesses in the third quarter and upgrading its full-year earnings forecast⁵.

Crucially, no one was talking about dividend cuts. All four of these companies have impressive track records of maintaining or growing their dividends over time. BP and Shell have historically maintained payouts even during times when oil prices have been significantly lower than they are today – in late 2015 and early 2016, for example, when oil prices briefly bottomed at around US$30 per barrel⁶.

However, with growth worldwide slowing down, lessening the risk of dividend disappointments takes on a greater importance. Just as diversification can be used as a tool to manage risks to capital, so it can be used to help smooth dividend distributions too. 

UK equity income funds have the potential to do both of these things, generating a growing income as well as some capital growth over time. They lend themselves to investors able to take a longer term view and who wish to benefit from an increasing investment income over the years that lie ahead. Fidelity’s Select 50 list of favourite funds features equity income funds which invest to these ends.

The JOHCM UK Equity Income Fund invests only in stocks expected to yield more than the FTSE All-Share Index in future. Every stock also has to have the potential to deliver capital appreciation. The Fund’s investment style can best be described as contrarian, emphasising stocks undervalued or underappreciated by the market as a whole.

The Fidelity Enhanced Income Fund also has a preference for undervalued stocks, which not only pay attractive dividends but grow them year by year. The Fund achieves a slightly higher yield than many other UK equity income funds through the sale of financial instruments related to its underlying investments (covered call options).

The Franklin UK Equity Income Fund invests partly in stocks with dividend yields greater than the market as a whole and partly in companies growing their dividends at a faster than average rate. Owing to this, the Fund is made up of a combination of shares with defensive qualities alongside shares more sensitive to changes in the economy. This fund tends to yield a bit less than either of the preceding two funds. 

Source:
¹ London Stock Exchange, 30.10.19
² ³ MSCI, 30.09.19
⁴ HSBC Holdings, 28.10.19 
⁵ BP, 29.10.19, and Royal Dutch Shell, 31.10.19
⁶ GlaxoSmithKline, 30.10.19
⁷ Bloomberg, October 2019

Important information 

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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