How secure are UK dividends?

Michael Clark
Michael Clark
Portfolio Manager, Fidelity MoneyBuilder Dividend Fund10 August 2018

From an income perspective, the UK equity market stands out from the pack in a couple of obvious ways. First, the yield is much higher: around 3.8% on the FTSE All Share vs 3.1% in the MSCI Europe ex UK Index, for example.

This is largely because the payout ratio is higher in the UK. Some of the largest stocks in the UK by market cap, for example Royal Dutch Shell (9% of the market), HSBC (6%), BP (5%), GSK (3%), Vodafone (2%), have payout ratios which range from 70% to 100% of earnings per share, well in excess therefore of the 50% normally considered prudent for a commercial business.

So the high dividend yield on the FTSE is generated by a small group of very large companies with high payout ratios, which is not the case in France and Germany. Given this situation, it is logical to ask the question whether these dividends are secure.

In the case of the oil companies, I felt that there were risks of dividend cuts, particularly at the time of the oil price collapse in 2014. But, since that time, the oil price has recovered, and the oil companies have increased production and cut costs. Consequently now the dividends seem much more secure.

In the other large companies mentioned, cash flow and profits have also improved and I would no longer expect dividend cuts at any of them. So I think that we can rely on the dividend flow out of large UK stocks, and we can take advantage of the high yields available here. But given the high payout ratio I don’t think we can say that there is a great deal of potential for these companies to increase their dividend. I also don’t believe that they are undervalued in capital terms, they merely pay out more of their earnings in dividends than some of their counterparts abroad.

Balancing global vs domestic exposure

The second way in which the UK market is different is the division between domestic-focused companies and global operators. Of the top 10 largest companies quoted in London, only one, Lloyds Banking Group, is a wholly domestic operation. Here it is arguable that there is undervaluation. At only eight times expected earnings for 2018, Lloyds is about five PE (price/earnings) points cheaper than the predominantly Asia-focused HSBC. This pattern is apparent in most of the other domestically focused stocks, and I would guess that this will not change until we see what the effects of Brexit really are.

High, well-supported yields can be found both in the global sector of the UK market and in the domestic sector. I think an income-based investment approach to the UK market currently needs to find a balance between these two spheres. 

Most of the global operators are in fine shape: we can point to strong oil prices, good GDP growth in most areas of the world, together with generally good operators in charge currently. All of these factors build up to a strong investment case for these companies. Domestic companies, while they may be cheap and well-run, suffer from the acute uncertainties overshadowing the UK.

So I recommend a selective approach to the domestics, focusing on stable business models with a low correlation to GDP. Utilities have a role to play here, as does the insurance industry and banking. I am cautious on construction (but not housebuilding), outsourcing, and retail.

In this way it is possible to put together a portfolio with a yield of 4.6% in the case of the Fidelity MoneyBuilder Dividend Fund, or 6.8% if enhanced by call overwriting in the Fidelity Enhanced Income Fund. However these yields are not guaranteed.

Glossary:

Payout Ratio: The proportion of earnings paid out as dividends to shareholders.

Price Earnings (P/E): A valuation ratio of a company's current share price compared to its per-share earnings.


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