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BLOG: How to make the most of the UK’s generous dividends

Paloma Kubiak
Written By:
Paloma Kubiak

Industry commentators – myself included – have been talking about the uphill battle to generate income for several years. As interest rates are so low, cash ISAs have struggled to pay out much income at all. And stocks and bonds have become expensive as investors turned to them in a hunt for yield.

This environment doesn’t seem set to change any time soon either, with the Bank of England announcing yesterday it will keep interest rates at just 0.5%. And, with the Bank’s 2018 growth forecast for the UK economy having been slashed from 1.8% three months ago to just 1.4%, low borrowing costs could stick around for a while yet.

So what is the alternative? The UK stock market, as measured by the FTSE 100, has now reached an average dividend yield of 4%. This is the first time in the last 20 years (with the exception of the 2008 financial crisis) that its yield has been so high.

There’s no doubt that, compared to the base interest rate of 0.5%, this is a much more attractive level of income. But the higher the yield, the higher risk the investment tends to be. After all, a company could be stretching itself thin if it pays a significant amount of its cash out to investors. Should the FTSE 100’s 4% yield be a sign that something is going awry?

One of the first ports of call should be to look at dividend cover. A recent study showed that the average earnings cover for FTSE 100 dividends is at 1.71 times for 2018. This is below the ideal earnings cover level of two times, which the study cited as the minimum needed to comfortably protect companies from any significant shocks or market falls.

In terms of the top 10 highest-yielding shares in the FTSE 100, the dividend cover situation looks even more tenuous, averaging out at 1.42x. And, if investors wish to hunt further down the market cap spectrum for opportunities, the average income offered is lower. For example, the UK mid-cap equity market, as measured by the FTSE 250, currently yields 2.71% and UK small-caps, measured by the FTSE Small Cap index, yields 3.14%.

So how can investors navigate the earnings cover issues within the UK stock market, while also generating an attractive yield?

We take a look at three Elite Rated funds which are doing their best to protect investors’ capital, while also yielding more than the FTSE 100.

Man GLG UK Income – 4.3%

Man GLG UK Income is headed up by Henry Dixon, who focuses his attention on companies with stronger balance sheets than the broader market, but which have twice the level of dividend growth.

Dixon also aims to avoid high-risk companies by making sure each of his investments are cash generative, but are undervalued relative to the quality of the business. This also reduces his chance of valuation risk. In other words, paying above-the-odds for a stock and losing money.

The manager is able to invest in a company’s bonds if he decides this is the best option, although at least 80% of the portfolio will be invested in UK equities at any one time. This means he has a slightly broader hunting ground when it comes to finding yield.

Threadneedle UK Equity Income – 4.2%

This fund is managed by Richard Colwell, who looks for unloved stocks which aren’t susceptible to market fads. In order to find these, he focuses on both the company’s individual fundamentals – in particular their ability to sustainably grow dividends – as well as the broader macroeconomic environment.

Colwell tends to find these companies in sectors or market areas which are undergoing change and, from there, looks for mispriced opportunities.

Royal London UK Equity Income – 4.08%

Royal London UK Equity Income is managed by Martin Cholwill. He believes that, when looking for income-paying stocks, the key is to focus on a company’s cash flow (the amount of money being transferred into and out of a business), because this is a tangible measure of how well covered their dividends are.

Cholwill looks for companies with strong business models and highly capable management teams, which he gauges through regular manager meetings. He also takes views on the broader macroeconomic backdrop into account.

To sum up, the fact that the FTSE 100 is now yielding 4% does mean that UK investors can generate an income for themselves. However, it also means that it is maybe more important than ever to choose the right active manager, who can generate an attractive income while also avoiding some of the higher-risk companies.

Darius McDermott is managing director of FundCalibre