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Investing for income: Brewin Dolphin’s top picks for income

Cherry Reynard
Written By:
Cherry Reynard
Posted:
Updated:
10/12/2014

Brewin Dolphin analysts give their top picks for income seekers, including funds, sectors and shares.

The Income Opportunity in Europe

The European equity market is an attractive source of dividend income but remains very much underappreciated by investors. In stark contrast, the UK equity income market is well developed with a large array of investment options available. While there are around 100 equity income funds in the UK, there are just 13 European funds. Restrictive regulation imposed on continental European pension funds has resulted in significantly higher allocations to bonds, and thus, there has been a much lower demand for equity income in Europe than in the UK.

By no means is Europe an inferior dividend generator however; the European equity market is the second highest dividend paying market in the world with a yield around 3.5%, almost equal to that of the UK. European equity income managers also have the luxury of choosing amongst a much wider range of dividend paying companies, there are over 250 companies in Europe with a dividend yield of 3.5% and above compared to around 80 in the UK. Many of these companies are high quality, globally focused, and generating sustainable and often growing dividends.

We regard European income funds as an important income diversifier but recognise currency is a key issue for sterling investors at the moment. Hopes are high that the ECB will embark on a more aggressive round of stimulus programs in the coming months and into next year, which we would expect to be positive for the troubled European economy. The most likely outcome of any such efforts, however, would be a weakening of the single currency. This would be particularly helpful for European exporters as well as those with more internationally diversified revenue streams, however, it would also detract from sterling based investor returns. The Argonaut Enhanced European Income fund, therefore, represents a compelling investment opportunity. Not only does it provide exposure to an improving European economy and earnings outlook but it continuously hedges the currency back to sterling.

Direct Line

Investors are likely to receive over 15% in income over the next twelve months, in our view (including disposal proceeds). We like Direct Line due to its return to pricing discipline, successful cost cutting and large dividend payout ratio, which we expect to have a positive impact on return on tangible equity metrics. Pricing in UK motor has been a headwind but this may turn into a tailwind, as evidence emerges that prices are stabilising.

The shares are down over 10% since September, due to concerns over pricing in the UK motor and home insurance markets. However, since then it has announced the sale of its Italian & German operations for £430m in cash to Mapfre at a very good valuation of 1.9x the 2013 net asset value. Direct Line plans to return the net proceeds to shareholders – we conservatively assume this will total 23p per share or 8.6% of the current share price (including tax and assuming it keeps a small proportion). Excluding the proceeds of the recent disposal, we were expecting a dividend of over 20p over the next 12 months (including c. 13p normal and c.7p in special dividends). This totals 43p or 16% of the current share price.

Vodafone 

We expect Vodafone to maintain its dividend (now yielding 6.0%) while it goes through a period of higher investment. Vodafone shares have underperformed since the return of value transaction in February (the cash and shares returned to shareholders after the disposal of Verizon Wireless) and after AT&T decided not to bid for the company (instead it bought DirecTV, a domestic content provider). At the first quarter IMS in July it reported that European revenue continued falling at a high rate, but did show some signs of stabilisation.

Since then we have become more positive on the shares. European revenue growth has been falling but we trends to improve over the next two years driven by reduced regulatory headwinds (not controversial) and an improved competitive environment as many of its disruptive competitors are now making very poor returns. Free cash flow will not cover the dividend for the next two years as it deploys extra ‘catch up’ capex (the £7bn ‘Project Spring’). However, after the Verizon Wireless disposal it has the balance sheet capacity to pay the dividend out of debt and has indicated that it intends to do so. After this period of elevated investment, management plans to return to a normalised capex level and we expect the dividend to be covered. Once the network upgrades are complete we expect consumers to respond and Vodafone’s relative position to improve.

Mining Sector

High quality miners such as BHP Billiton and Rio Tinto are now yielding over 4.5% and should be able to grow their dividend by at least high single digits even if commodity prices remain low or fall slightly from here. We believe that commodity prices could rise between now and February due to seasonal restocking. Both companies may choose to accelerate returns to shareholders as a takeover defence (Rio Tinto) or due to investor pressure (BHP Billiton). There are five reasons to be positive today, in our view.