Neptune's Geffen on the outlook for equity income

Robin Geffen and Emma Stanford from Neptune Investment Management say demand for income coupled with a low supply should allow UK equity income funds to generate significant returns this year.

Searching for yield has become increasingly difficult for the UK equity income manager over the last decade. Indeed, 2009 was no easier with total dividend payments down by £10bn and 2010 will be a year where yield is again hard to find.

In an environment of near-zero interest rates and corporate bond yields coming down, income-generating equities look particularly attractive as they offer the twin benefit of capital growth alongside dividend payments. We believe dividend income will represent a significant proportion of the returns in the UK market in 2010. A higher demand for income, coupled with lower supply should allow UK equity income funds to generate significant returns.

Dividend cuts

The UK equity income pot has been shrinking for a long time. This trend accelerated in 2003-06 as private equity bought up cash-generative, dividend-paying companies, particularly in the utilities sector.  As companies such as Scottish Power, Abbey National, Safeway, Gallaher, BAA and O2 left the market, £5bn of annual dividend income was lost.

The financial crisis forced many companies to cut their dividend but most importantly, the banking sector (historically an important source of growing dividends) near eliminated their dividend payments. Now only 15 stocks contribute two thirds of the UK market’s overall equity income, and BP, Royal Dutch Shell and Vodafone now account for nearly a third of dividends.

In 2009, shareholders in the UK saw dividend payments cut by £10bn compared to 2008, a fall of 15%, as so many income funds had to cut their distributions. For example, the funds in the recent White List study (12 of the best UK equity income funds according to Principal Investment Management) experienced an average year-on-year drop in dividend of 8%.

However the outlook for dividends is better in 2010 as companies start to pay a dividend again or are able to grow their dividend in line with a recovery in earnings.

A collapse in savings rates due to near-zero interest rates and falling corporate bond yields has left UK savers with few options for income. Current UK equity yields are looking very attractive relative to the rest of the market. The FTSE All Share yield is 3.68% (Bloomberg 24/02/10) only marginally below the yield on a UK 10-year treasury of 4.08% (Bloomberg 24.02.10).

Some companies offer a better yield on their equity than on their corporate bonds, for example, BP offers a 6.12% equity yield as opposed to 2.9% on its five year corporate bond. These equities offer the potential for capital growth in addition to their attractive yield.

Some further good news for the UK equity income sector is the Government has increased incentives to save in ISAs. In 2009, the Government increased the allowed contribution into an ISA from £7,200pa to £10,200pa, effective October 2009 for the over 50 and effective April 2010 for everyone else. This will allow retail investors to invest a higher proportion of their savings tax-free.

For those investors looking for income, this is a significant advantage as income is paid free-of-tax (after the 10% dividend tax). For those willing to take a long-term view, ISAs are now the favoured tax-efficient savings vehicle to build a long-term nest egg. With ISA investors increasingly looking for income from their savings, the UK equity income sector will be one of the main benefactors.

Sector performance

UK equity income funds struggled to outperform the FTSE All Share in 2009. While benefiting from the significant uplift in capital values, funds struggled to keep pace with the rally in low yielding sectors such as financials and industrials, that were being re-rated as the worst of the credit crisis receded.

Many of the best performing stocks were those that were on the brink of bankruptcy and not only had extremely weak balance sheets they also did not pay a dividend or that dividend was at risk. This made it difficult for income focused funds to outperform in the rally. This was particularly true of funds like the Neptune Income fund, which has the objective to preserve capital, and with that in mind, we avoided companies with weak balance sheets.

The market ignored high quality companies with a strong history of dividend growth in favour of more economically sensitive stocks. This left traditionally high-yielding sectors such as the telecoms and healthcare sectors to underperform, meaning they now offer very attractive valuations relative to the market.

Neptune’s global sector research is at the heart of our income investing process. Sector selection will continue to be important for the income sector. In 2009 it was the utilities, telecoms and energy sectors which offered the most attractive yields. This is still the case today as they currently offer 5.7%, 5.9% and 5% yields respectively (source: Bloomberg as at 05/03/10). These sectors also offer some of the most attractive valuations.

Banks will have to rebuild balance sheets for some time to come before they can pay significant dividends again; with new regulation that is likely to include higher required capital levels, their focus will be on retained earnings. While banks cut overall dividend distributions by £6bn in 2009 compared with 2008, Standard Chartered actually increased its dividend year-on-year, showing that through careful stock picking, dividend cuts can be avoided.

After their significant underperformance last year the utilities sector looks likely to perform better in 2010. One area where we have turned more positive is the water utility sector.

Following the lift of regulatory uncertainty, these stocks look set to benefit from a lower cost of debt and inflation pass-through.

Emerging markets

We believe growth in the developed world will be muted, so companies with exposure to emerging markets will, by in large, be the ones to grow or gain market share. Using conservative assumptions, our economic research suggests over the next five years the emerging markets will provide no less than two thirds of incremental growth in global GDP.

With around two thirds of earnings of the FTSE 100 coming from abroad there are plenty of opportunities to access international growth with UK companies. The £11.7bn takeover of British chocolate manufacturer, Cadbury’s, underlines the attractions of high quality, income-generating stocks where there is a high level of free cash flow and growing earnings from emerging markets.

Historically, 40% of investor returns in the UK have come from dividend payments. In 2010, the market will likely experience slower growth, meaning that a greater proportion of available returns will come from dividends. Companies with earnings resilience, consistently strong cash flows and rising dividends should perform well. We believe the current low valuation of many of these defensive companies with high yields offer an excellent buying opportunity.

UK equities with income are likely to outperform this year due to the higher demand, as other areas of the market offer lower yield, limited supply and attractive valuations from their relative under-performance last year.