The FTSE 100 may have hit news highs in recent weeks, but there is a tougher reality behind the jubilant headlines.
Until recently, the UK stock market had been in the doldrums, unloved by domestic and international investors. However, a combination of merger and acquisition activity, share buyback activity and an improving domestic economy may be helping it revive.
In recent years, investing in UK companies has been tough. Although many companies continued to perform well operationally, share prices remained stubbornly low. Low valuations were not enough by themselves to tempt investors back to the UK market.
However, a number of factors appear to be starting to make a difference. There has been significant buyback activity, with Shell announcing a $3.5bn buyback at the start of May, alongside many of the other major FTSE 100 companies including BP, Unilever, Barclays, and HSBC. Share buybacks are designed to reduce the number of shares in issuance, and should make each share worth more.
Merger activity
At the same time, merger and acquisition is picking up, with a number of high-profile bids for UK companies, including Anglo American, Direct Line and Currys. US private equity investors are taking a growing interest in UK companies, apparently recognising that there is value there.
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All of these factors are also true for the small and mid-cap part of the market. They have suffered most from the general unpopularity of the UK market and now appear cheap relative to their own history and to their international peers.
They are also seeing both buyback and takeover activity, which is helping to support share prices and are an important source of potential growth and income for UK investors.
Dividend strength
While we believe we may be on the cusp of a revival for the UK stock market, predicting when and how that revival will build momentum is difficult. This is where dividend stocks come in. A focus on growing dividends can provide a measure of stability and predictability in various market cycles.
It is also a source of potential long-term growth, compounding over time, until share prices recover.
The dividend yield on the UK market is higher than for almost any other major market. The FTSE 100 has a yield of 3.6% (source: FT). However, investors are not confined to larger capitalisation companies when looking for income.
The FTSE Small Cap has a yield of 4%. The FTSE 250, which represents medium-sized UK companies, has a slightly lower yield, but still holds plenty of income opportunities.
In effect, investors in the UK market can target traditionally higher-growth areas such as smaller companies, but still receive a growing dividend.
It is worth noting that this dividend income should grow over time. Dividends in the UK market are currently growing at around the longer-term rate of inflation, at 2-3%. There are also companies that are growing their dividend faster than the market alongside sustainable cash flow, putting them in a position to grow their payouts over time.
We believe targeting growing dividends can guide investors to companies with stable, long-term growth and capital discipline. This should be a more productive strategy than targeting the highest dividends and helps us identify companies with growth and stability.
Ultimately, there are reasons to be hopeful about the outlook for the UK market, but in the meantime, dividends allow us to wait until the market recognises the value in UK companies.
For more information on how to access the opportunities presented by the income and growth sector, visit Blackrock.
Adam Avigdori is co-manager of BlackRock Income and Growth Investment Trust
Related: The UK is a ‘no-brainer’: Why we’re bullish on UK equities
