Retail investors’ love affair with income appears as solid as ever despite a rough period for some of the UK’s biggest dividend-paying companies.

Latest figures reveal that private investors ploughed £520m into UK equity income funds in August at a time when the outlook for UK dividends seems bleak.

Dividend covers– the measure which shows how affordable and sustainable dividends are – are at multi-year lows for the UK’s largest listed firms. Much of this deterioration is down to FTSE 100’s exposure to oil and gas and mining stocks, which have been hurt by falling commodity prices, and which typically pay big dividends.

Mining giant Glencore is probably the most high profile casualty. Its share price fell to a record low in September. But shares in rivals BHP Billiton, Rio Tinto and Anglo American have also suffered.

Another sector under the spotlight is retail with supermarket giants Tesco, Sainsbury’s and Morrison’s all slashing their dividends this year thanks in part to pricing pressure from discounters.

Managers of UK equity income funds admit that falling earnings are a concern.

“In 2014, earnings of the FTSE 350 fell 2% but dividends went up 3%. These companies can’t keep paying dividends when earnings are going down. It’s not sustainable,” says Eric Moore, manager of the Miton Income fund.

Mid and small caps

Against a testing time for large chunks of the FTSE 100, investors might consider the mid and small cap space for income

“Here we think the earnings growth outlook is strong, reflecting a greater exposure to UK domestic growth,” says Jason Hollands, managing director of investment and financial planning firm Tilney Bestinvest.

He tips the Standard Life UK Equity Income Unconstrained fund, which has 43% in mid caps and Unicorn UK Income, which has a significant proportion in smaller and mid-sized companies.

Global 

Another option is global equity income funds.

One downside to these products is they are often benchmarked against the MSCI World Index, which has a 57% exposure to the US, and the US is historically a lower yielding market for tax reasons and due to a preference for share buybacks. The market pays out just 30% of global dividends.

Hollands says one global equity income fund that has “successfully squared this circle” is the Artemis Global Income fund which takes an unconstrained approach to stock selection.

Manager Jacob de Tusch-Lec says a global approach to income investing opens up your investable universe.

“You have more choice. You can find a stone that hasn’t been turned 50 times,” he says.

“The UK and US are so well researched. But going global means you can invest in New Zealand, for example, where I own a casino stock or Mexico where I own a REIT, which yields 8% and pays out in US dollars. You can put together a more diversified portfolio.”

Another advantage of a global remit is access to a broader range of sectors for income. Oil companies and pharmaceuticals play a huge role in dividends in the UK, for example, but less so in other regions.

The US is home to a range of technology companies such as Intel, IBM, HP, and Cisco Systems, some of the US’s highest yielding stocks.

Europe

For investors prepared to cherry pick regions, Hollands says Europe looks interesting for income seekers.

“European equity markets continue to be supported by the ongoing quantitative easing programme, which is scheduled to run to September 2016, and the recovery continues to make progress,” he says.

De Tusch-Lec has 50% of his fund in Europe where he thinks “valuations are good”.

Hollands likes the Standard Life European Equity Income fund which targets companies undergoing a catalyst for change, such as restructuring, or which will benefit from a change in regulatory environment. For example, the manager has recently been buying into well-capitalised Italian banks Intesa SanPaolo and Mediobanca, which should be beneficiaries of banking reform.

Japan

Japanese companies have been notorious for hoarding vast amounts of cash on their balance sheets rather than paying out a dividend. But the culture appears to be shifting.

The recently-adopted Stewardship and Corporate Governance Codes, which formed part of prime minster Shinzo Abe’s three-pronged reform package, have put pressure on companies to increase shareholder returns.

Simon Somerville, manager of the Jupiter Japan Income fund, says: “The codes have forced institutional investors to begin actively voting, meaning there is a lot more pressure from domestic investors on companies to do the right thing for their shareholders.

“This has forced managements to become more focused on return on equity, to look at the cash on the balance sheets and either return it to shareholders or plough it productively back into their businesses. The positive impact of these measures is already clear to see: dividends last year rose by 13%, and share buybacks soared by 79%. This year Nomura estimates total shareholder returns will rise 14%.”

While there is clearly a dividend growth story in Japan, it is starting from a low base.

Hollands says: “Toyota currently has a pay-out ratio of just 27%, which would be considered derisory for a FTSE 100 company. So those needing income today will still find better opportunities elsewhere.

“But clearly there is plenty of headroom for further growth.”

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