By Stephen Message
One of the tasks facing income investors in the UK market arises from the fact that a significant amount of dividends are delivered from just a handful of companies, so achieving diversity in income can be a challenge.
At the moment we are uncovering many interesting income opportunities in medium-sized businesses, particularly in terms of their dividend growth prospects. Examples in the portfolio include packaging business DS Smith, pub group Greene King, broadband provider TalkTalk, specialist lender Provident Financial and asset manager Aberdeen.
It is fascinating how investor mindset has changed over the past few years with regards to the capital structure of a company, specifically over what constitutes an ‘efficient balance sheet’. In the years preceding the financial crisis, many businesses were encouraged to take on ever increasing amounts of debt, which had the effect of boosting returns on equity for shareholders in the short term, only to subsequently suffer during the recession.
Post the financial crisis it is now the opposite as companies have typically been paying down debt, to the point where some are considering they have excess capital that is surplus to requirements and have rewarded shareholders with special dividends. These are one-off payments to shareholders in addition to regular dividends which further enhance investor income. Examples have included plumbing merchant Wolseley, cruise line operator Carnival, chemicals company Johnson Matthey, hotels business InterContinental Hotels and speciality insurance group Lancashire. We think this feature will continue to be prominent in the coming year.
We believe consumer confidence is beginning to stabilise and we have introduced a number of businesses serving the consumer into the portfolio. Examples include Carnival and US-focused jewellery retailer Signet. We would also not write-off the prospects for a number of domestic companies because it is often in tough times that the strong get stronger while the weaker fail. Well managed, competitively positioned companies should be able to take market share and we are exploiting this theme through investments in cash and carry operator Booker Group, Greene King and budget airline Easyjet.
We are not in the camp that bank shares are ‘un-investable’ with holdings in Lloyds, Standard Chartered and HSBC as we feel that returns on equity can continue improve in the coming years and there is still considerable investor pessimism towards the sector.
Also while we would not dispute that a number of companies in the consumer goods space, including beverages and food producers, have delivered solid operational results, we would argue that this is now reflected in the strong premium valuations these companies possess and so are generally avoiding this area. We are also cautious on the outlook for the food retail sector as despite offering premium dividend yields compared to the market, competition is intensifying after years of rampant space growth and so in our view the prospects for dividend growth are fairly muted.
Stephen Message is manager of the Old Mutual Equity Income fund
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