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Where should income investors put their money?

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Fund managers share their outlook for UK dividends and reveal the best income plays in the market today.

Investors in US-listed shares are set for a bumper year, with companies across the Atlantic expected to increase their dividend pay-outs.

Goldman Sachs predicts that US corporates – many of which are currently sitting on large cash piles – will return $400bn to investors in the form of dividends, a 7% annual increase.

But is the outlook for UK firms and investors as healthy? According to Capita Monitor’s latest dividend report, it is.

Published in April, it said dividend pay-outs, excluding special dividends, should reach £84.1bn this year, an increase of £500m compared to Capita’s previous forecast. This represents a 6.4% growth year-on-year. If that total is achieved, 2015 will be the best year for dividend growth since 2012, the report said.

Some fund managers think that corporate earnings forecasts will act as a drag on dividend pay-outs. But evidence suggests that these two data points are not necessarily correlated.

According to the latest data from IBES, which collates analyst forecasts on UK listed firms, corporate earnings growth of FTSE 350 companies was down 2% in 2014 but dividend growth was up 3%. This year, while earnings growth is predicted to fall 9%, dividend growth is forecast to rise 6%.

So which companies should income seekers focus on?

Small- and mid-caps best for dividend growth

Thomas Moore, manager of the UK Equity Income Unconstrained fund at Standard Life Investments (SLI), believes the best opportunities for dividend growth this year in the UK will be in the small and mid-cap space.

“Large caps are still growing their dividends but they are in a less strong position. Take the oil sector, for example, where earnings are going backwards. The oil and gas sector accounts for 13% of the FTSE All Share but earnings are forecast to be -45% for 2015.

“Companies like Shell and BP will have to cut costs, which will have a big impact on dividend growth potential,” he says.

In the mid and small-cap space, Moore expects “double digit growth” this year.

One theme he is currently playing is the recovering consumer. With record levels of employment and real wage growth, he says it is hard to be bearish on the consumer at the moment.

“Some will say the consumer is in too much debt but those arguments are beginning to become too tenuous. The real pick up in employment markets cannot be ignored. If corporates are optimistic and are hiring more staff, it’s a genuine recovery,” he says.

The consumer sector is the SLI fund’s biggest overweight.

The manager recently added Super Group, the company behind the Superdry fashion brand, to his portfolio.

He explains: “It has had issues building out the brand globally and expectations were low. It was also caught out by the mild weather last autumn.  But this was a short term issue. Despite growth, its valuation was down below the market level.

“Management has said it will invest in new opportunities, increase its presence online and try to gain more traction in the US. It has also announced it will pay a dividend in the next year.”

A more subtle way to play the consumer theme, Moore says, is through the financials space, in particular via companies that can benefit from the UK economic recovery without facing the onus of heavy regulation. He owns Paragon, the buy-to-let mortgage lender.

“It is seeing very strong levels of application from high quality customers who are often professional buy-to-let customers – seen as SMEs. It knows its customer well and is making sensible lending decisions.

“Most banks are not lending to these customers because of the risk weighting attached to them,” Moore says.

Under regulatory rules, lenders have to set aside more capital in relation to what they lend for these types of borrowers compared to say first time mortgage applicants.

“Paragon’s cash flow is increasing which will be a benefit in terms of dividends coming through. And in May the company increased its 2015 interim dividend by 20%.”

Moore also holds Tyman, an AIM-listed stock which makes seals for doors and windows. This, he says, is a play on the pickup in new home sales on both sides of the Atlantic and in home improvements as earnings go up.

Opportunities in large caps but be selective

While small and mid-caps look attractive, large cap companies should not be dismissed outright.

Eric Moore, manager of the Miton Income fund, owns a number of blue chips including BT, ITV and L&G, which according to their last full year numbers, grew their dividend by 14%, 34% and 21% respectively.

He tips the pharmaceutical sector, where he owns, among others, GlaxoSmithKline and AstraZeneca.

“These companies are not as reliant on economic growth and do not have large regulatory pressures,” he says.

On the topic of regulation, his views on the banking sector have shifted lately. Previously he had drawn a line through it as there were no dividend opportunities. But he has recently bought some shares in Lloyds Banking Group.

“The business is very cash generative and there isn’t much it can do with the money apart from giving it back to shareholders,” he says.

“Unless the regulator gets in the way.”

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