Why it can be good to look away from the most popular income stocks
Finding the best dividends outside the FTSE 100
The UK equity income sector has a long-standing problem with concentration, with just ten FTSE 100 companies accounting for around half of all UK dividends. Many traditional UK equity income funds have significant weightings within these same stocks. So even if you spread your money across several of these funds, chances are you’ll remain heavily exposed to a handful of the same large companies. This creates concentration risk.
Fortunately, we believe there’s a simple way to diversify your exposure while delivering a sustainable and growing equity income stream. And it can more than hold its own against the more traditional approach. Please remember that investment in smaller companies can involve greater risk than may be associated with investment in larger, more established companies.
Big names, but there is another way
Big, established names are popular with income investors for obvious reasons (they pay out a lot in dividends) and this does have its advantages; the people running these companies obviously know that many of their investors hold the shares specifically for the dividend. To that effect, managers are mindful of maintaining the dividend, and ideally growing it a little bit each year because that’s what shareholders are looking for. But FTSE 100 investors rely very heavily on the biggest dividend payers for their income, as shown below.
There is, however, another way to approach equity income, and that’s by looking across the entire UK equity market. To add some context, in the FTSE Aim Index, if you exclude the non-dividend payers, the average dividend yield is now an attractive 2.5%, with AIM dividend pay-outs increasing by over 15% in the year to end 2018. AIM dividend pay-outs have in fact tripled since 2012, versus a much more modest 45% increase across the rest of the market.
Therefore, by looking across the wider market, and not just concentrating on the ten traditional companies, investors can benefit from a sustainable equity income stream that’s more than capable of growth. It’s worth keeping in mind that smaller companies can fluctuate more in value than their larger counterparts and they may be harder to sell.
Where to look for dividend growth
One approach which investors can consider is core-satellite approach, whereby ‘core’ investments are generally dividend payers selected from across the entire UK equity market. They tend to be proven winners, with robust finances, and superior prospects for profit growth.
Examples of this kind of company include:
- STV, a leading Scottish-based broadcaster and TV production business. With a market capitalisation of around £150 million, STV pays a dividend yield of around 5.5%. STV is expecting further growth in its digital and regional revenues and improved performance from its production arm, which should help the company grow the dividend by around 5% in the year ahead.
- MJ Gleeson, a low-cost housebuilder and strategic land developer. MJ Gleeson currently pays a dividend of around 3.8%, and grew its dividend pay-out by nearly 8% in the year to June 2019. There’s significant scope for further growth by building low-cost homes for first-time buyers and low-income families, a market still underserved by other housebuilders.
- Ten Entertainment, a leading operator of bowling and family entertainment centres. This company is continuing to grow via a combination of opening new sites and making improvements to existing ones. The dividend yield is around 4.7%, with dividend growth of 8% likely to be delivered for the financial year to December 2019.
Alongside the core holdings, ‘satellite’ investments are chosen, which are intended to be more actively managed due to their higher risk, but hold greater potential for growth. Investors may like to separate this into two satellite clusters: one which may offer slower earnings growth potential, but provides the portfolio with superior sustainable dividends; and one cluster of companies which may be at the earlier stages of their dividend journey, but could offer exceptional growth potential.
FP Octopus UK Multi Cap Income Fund
This Fund isn’t constrained by investing in any one part of the market. Instead, we look to assess each holding on three key characteristics:
- the ability to deliver a dividend yield in excess of the wider market,
- the ability to deliver faster than market earnings growth, and;
- the ability to deliver faster than market dividend growth.
The chart below shows the earnings and dividends growth for the fund’s largest holdings versus the 10 ‘mega-caps’ responsible for 53% of all UK dividends. Factset, data run 5 December 2019, based on 4-year Compound Annual Growth Rate (CAGR) for earnings and dividend growth.
This differentiated, multi-cap, approach gives us the opportunity to buy potential equity income stars of the future, before many more traditional income funds would consider them – whilst also holding more traditional dividend-paying stocks.
The strategy has paid off as FP Octopus UK Multi Cap Income Fund in 2019, its first full year since launch, outperformed every other fund in the IA UK Equity Income sector on a total return basis.
Risks to bear in mind
The value of any investment can fall or rise and you may not get back the full amount you invest. Smaller company shares are also likely to fall and rise in value more than shares in larger, more established companies listed on the main market of the London Stock Exchange. They may also be harder to sell. For the FP Octopus UK Multi Cap Income Fund, fees will be deducted from capital which will increase the amount of income available for distribution. However, this will erode capital and may hinder capital growth.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees