Lessons from Vodafone: how to diversify your income portfolio
Vodafone shocked its loyal army of income investors this week with a 40% dividend cut, on account of flagging revenues.
It’s a move that will not only serve as a blow to investors across the UK, but also underscores the perils of relying on a handful of the UK’s largest companies and their seemingly attractive dividend payouts. Following Vodafone’s dividend cut, investors are concerned that other FTSE 100 names could follow suit.
Chris McVey, who manages the FP Octopus UK Multi Cap Income fund, notes that ten stocks currently account for more than 50% of FTSE 100 dividend payments. Prior to its dividend cut, Vodafone was expected to generate more than 9% of this.
“Given these expected payouts, a large proportion of traditional income funds hold these ten stocks, leading to significant holding concentration. This is despite often lacklustre profit growth expectations, and in some cases limited dividend cover,” McVey pointed out.
This underscores the importance of diversifying your income portfolio across different parts of the UK market, as well as gaining exposure to attractive dividend-payers abroad.
Small and mid-cap gems
McVey is particularly keen to stress the potential benefits that small and mid-caps can offer.
“Small and mid-sized companies consistently outperform their larger peers, while demonstrating this faster growth in earnings and dividends,” he explained.
For example, he is currently bullish on the prospects for STV, the Scottish TV channel, as well as construction company Watkins Jones.
Ken Wotton, manager of LF Gresham House UK Multi Cap Income fund, notes that many UK equity income strategies are disproportionately invested in a relatively small number of mega-cap stocks.
“However, this herding has created an opportunity for managers willing to go beyond the status quo,” he added.
When it comes to opportunities in the small and mid-cap space, he is spotting numerous under-researched and under-the-radar companies with the potential for dividend growth over the coming years.
“These stocks are also typically trading at a valuation discount to larger, more well-known peers,” he said.
One example is Vianet Group, a data services provider which operates in the pub and vending machine sectors.
“By monitoring the flow of beer in pubs, its proprietary equipment helps companies optimise barrel yield and limit waste. In the vending machine space, Vianet uses an automated communications process for collecting data, which optimises yield by monitoring sales and pre-empting maintenance,” Wotton explained.
Looking outside the UK
There’s also something to be said for diversifying away from the UK market.
“Diversifying across geographies means less exposure to an issue in any one jurisdiction, such as a currency swing or a change in the tax regime. The impact of the tit-for-tat tariff hikes between the US and China, for example, highlights the benefit of having investee companies that operate and sell in different regions of the world,” explained Ben Peters, co-manager of the Evenlode Global Income fund.
In addition, Peters is a firm believer in making sure your portfolio is diversified across different sectors and market caps. For example, he highlights US publisher John Wiley & Sons as an exciting mid-cap stock to watch.
“The company has high levels of cash flow that fund the dividend, but this is also being used to move into new areas delivering digital services to higher education institutions, drawing on its heritage in academic publishing, which is also digitising rapidly,” Peters said.