Chris McVey, Senior Fund Manager at Octopus Investments, discusses why investors looking to diversify their portfolio shouldn’t necessarily put all their eggs in the biggest baskets
Multi cap approach could pay greater dividends for UK equity income
The UK equity income sector has had a long-standing problem with concentration, with ten ‘mega cap’ FTSE 100 companies making up 53% of all UK dividends.
Many traditional UK equity income funds have substantial weightings within these same stocks too. So even if you diversify exposure across several of these funds, chances are you’ll remain heavily exposed to the same larger holdings.
|Stock||Number of funds as top 10 holding||As a %|
|Royal Dutch Shell||55||65|
|British American Tobacco||32||38|
|Legal and General||23||28|
Source: Octopus & Lipper, May 2020.
This means massive asset correlation and massive asset concentration amongst a relatively small number of names.
Given the effects of the coronavirus pandemic on the UK economy, the concentration of these holdings has become more apparent, making the need for diversification that much greater.
Fortunately, 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 investing in smaller companies can involve greater risk than may be associated with investing in larger, more established companies.
High paying dividends aren’t being matched by earnings
Large companies in the market are popular with investors because they pay out a lot in dividends. The people running these companies also know many of their investors hold shares specifically for the dividend, meaning they’re mindful of maintaining and growing it a little each year.
And while the average dividend per share growth has been strong for the mega caps over the last ten years at more than 9%, the average earnings per share growth for the same companies over this period has been a meagre 0.3%.
What’s more, if we look at the dividend cover of these top names over the past decade, the average cover of over 4x back in 2010 rests in the region of 1.5x today, primarily because these attractive payouts haven’t been sustainable.
Finding the sweet spot
Of course there’s no hard and fast rule, but the greatest opportunity within the market, then, seems to lie within this sweet spot of dividend growth and earnings growth. The small, mid-cap space (above 100m, but below 1bn) where a lot of companies are on a steady growth trajectory is where taking a multi cap approach comes into play. 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. This approach could compliment a portfolio where there are already holdings in those mega caps.
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.
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
- The ability to deliver faster than market 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.
While consensus estimates are likely to see some further adjustments given the uncertain economic outlook, the predicted weighted average dividend cover across the Octopus UK Multi Cap Income Fund is currently over 3x for 2021.
This is actually an increase from pre-covid levels of around 2.3x, although there have been a number of dividend cuts across the portfolio since then.
Nonetheless, the increased level of cover across the Fund gives us confidence that many of its holdings remain well positioned to reinstate dividends in the relatively near term, and to grow their dividends pay-outs going forward.
To put things in perspective, the same consensus data for the ten largest dividend payers within the UK market estimates an average cover in the region of 1.42x for 2021, despite the well flagged dividend cuts.
Growth and income potential
Within the Octopus Multi Cap Fund, we have a strong portfolio of companies that we believe lie on this 3-5 year steady trajectory of matched dividend growth and underlying earnings. Here’s a closer look at some of them:
Strix Group Plc - £380m market cap
The global leader in kettle safety control technology with over 50% market share. Strix management paid its final 5.1p dividend in May, and on a prospective basis for the year to December 2021, the stock is expected to pay a healthy 4.3% dividend yield at current levels, with the Dividend per Share pay-out expected to grow by c.4% on the previous year.
Emis Group plc - £670m market cap
EMIS is a leading UK provider of IT software and systems for the healthcare industry, and importantly right now, for the NHS. With approximately 80% recurring revenues, and a balance sheet with over £40m net cash, the group paid its final 15.6p dividend last month. At current levels, the group is expected to deliver an attractive prospective yield of 3.3% for the year to December 2021, with the dividend per share pay-out expected to grow by c.6.2% on the year to December 2020.
Spirent Communication - £1.4bn market cap
Spirent is a leading technology and testing provider for the communications sector. The prospective dividend for the year to December 2021 is about 2.1%; however the dividend per share pay-out is expected to show a healthy year on year increase of over 11% versus December 2020.
In 2019, the FP Octopus UK Multi Cap Income Fund outperformed every other fund in the IA UK Equity Income sector, in its first full year since launch, on a total return basis.
If you’d like to find out more about the Fund and its holdings, read more on the Octopus Investments website.
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