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Disappointing dividends: Three tips for income investors

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UK dividend growth is at its lowest level for more than three years according to a new report. What's an income-hungry investor to do?

The latest Capita Dividend Monitor found that UK dividends grew a measly 1.2 per cent through the second quarter of 2014 as a strong pound impaired the overseas income earned by UK companies.

According to Laith Khalaf, senior analyst at Hargreaves Lansdown, it’s difficult for UK equity investors to protect against currency movements – which can work for or against them – but there are certain steps they can take.

He says: “Equity Income investors should focus on the long-term dividend story rather than paying too much attention to quarterly movements. While dividends may be growing more slowly than this time last year, they are still growing, and still look relatively attractive in a world hungry for yield.”

Here are three of Khalaf’s tips for investors seeking income in the current environment:

1. Focus on the long term

“The long-term appeal of Equity Income investing is not diminished by one quarter of disappointing dividend growth. The reason for investing in Equity Income is the potential for both capital and income to grow over the long term.

“The capital growth part of this equation is often overlooked. But the IMA UK Equity Income sector has turned a £10,000 investment in 1989 into £29,510 today in capital growth, on top of the dividends provided along the way. If dividends had been reinvested this £10,000 would now be worth £70,670.

“A £10,000 investment with Neil Woodford in Invesco Perpetual High Income (run by Mark Barnett since March 2014) would now be worth £74,390 on top of the dividends provided. This £10,000 investment would have generated £2,298 in dividends in 2013. Or, with dividends reinvested, this £10,000 investment would now be worth £196,850.”

2. Look down the cap scale for income

“Most UK Equity Income managers predominantly hunt for income opportunities amongst the big blue chip companies which make up the FTSE 100. However Capita’s report suggests the dividends of the very biggest stocks are suffering from the effect of a strong sterling to a greater extent than the rest of the market. FTSE 100 dividends rose 0.5 per cent compared with 2.6 per cent growth from the FTSE 250.

“Equity Income investors might consider broadening their portfolio to include more mid-cap and small-cap exposure, where companies tend to be more domestically focused and less exposed to overseas earnings.

“Marlborough Multi-Cap Income focuses on building an income-producing portfolio from mid-cap and small-cap companies. Currently around 80 per cent of the portfolio is held in mid and small-caps. This fund can provide a good complement to more large-cap orientated funds like Woodford Equity Income and Threadneedle UK Equity Income.”

3. Consider investment trusts

“Investors could also consider investing in income-producing investment trusts. Investment trusts are permitted to hold up to 15 per cent of their dividend income back in reserve each year, to be paid out at a later date.

“This means the trust can smooth the ups and downs of dividend payments to some extent. Of course over the long term investment trusts receive the same income as open ended funds, but the reserving mechanism means they may be able to make payments less lumpy for income investors.”

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