Investing in equities for income should be as relevant now as ever.
Our population is ageing and in need of income in retirement.
Alternative sources such as bank deposits or bonds offer next-to-nothing in this period of persistently low base rate environment.
It has always been my view that equity income should aim to deliver a defensive total return for investors, placing emphasis on a growing and resilient capital return, complemented by a progressive income component.
Logically, the equities most likely to deliver this are cash-generative, growing businesses bestowed with compelling economics.
So why have UK equity income returns lagged recently, and how do we best position investors for the future?
The challenge for UK dividends
The composition of the UK market has long been problematic. The FTSE All Share Index has been dominated for decades by a relatively small number of large businesses, some with lousy economics.
They have proven to be cyclical, hugely capital intensive and often failed to grow.
Worse still, from an income perspective, in desperately striving to provide some return to investors, many have fallen into the trap of paying unsustainable dividends such that their contribution to the overall market’s dividend became disproportionate.
Key points
- Equity income is more important than ever
- Many companies have been paying unsustainable dividends; while Covid-19 caused other companies to cut dividends or suspend them
- It is important to consider sustainable growth of a stock
We estimated, heading into 2020, approximately 50 per cent of the UK market’s collective income was projected to come from just 10 companies, many of whom had clear vulnerabilities to their business models.
The Covid-19 pandemic has brought a swift and brutal reckoning for UK dividends, but the ingredients for dividend cuts were long in the making.
Alarming as this backdrop may be, I hold out hope that a more prudent approach to dividends will be taken by companies and shareholders, to the benefit of total return. I believe three factors will be key in delivering attractive equity income returns in the future.
• Investing in UK companies, not the index.
We must be careful not to confuse dynamics impacting the market-cap weighted index with UK companies as a whole. The UK remains a significant market globally.
It has strong corporate governance standards, fast-developing environmental, social and governance credentials and, most importantly, a number of high-quality businesses worthy of investors’ capital.
As professional investors scour the world, they find the UK to be home to a select group of businesses that possess the characteristics that many look for; high returns on capital, expanding end markets and powerful intangible assets that are hard to replicate.
World-class companies can be found in areas including consumer goods, speciality industrial and data/software for instance. The fact that the UK has some very large companies lacking these traits is not overly relevant, in my opinion.
It is better to eschew investments in companies that do not fit the criteria, no matter their position within the index. Investors should look beyond, rather than be beholden to, the skewed index.
