Building an equity income portfolio
It made sense that traditional equity income portfolios have focused on the companies of the London Stock Exchange, and in particular the exchange’s largest companies. The UK has consistently one of the highest-yielding markets in the world. The FTSE All-Share index currently yields 3.3%, so even tracker funds pay out a reasonable income compared to a savings account.
The highest yields are typically found in the biggest companies. Mature companies typically have less need to invest – they might have already built up sufficient assets, or they might have run out of profitable ways to expand. As a result they’re more likely to pay out cash to shareholders. Companies know investors such as retirees rely upon these dividends for income, so they will typically pay them out through thick and thin, only cutting them under extreme duress.
In many cases the sums involved are huge. The top dividend payer in 2013, Royal Dutch Shell, paid out a whopping US$11.3 billion to its shareholders. When Vodafone sold its 45% stake in US mobile operator Verizon Wireless earlier this year, they also paid £51 billion of the proceeds to shareholders.
For all the talk of the UK’s decline as a manufacturing power, it’s easy to forget that there are still world-leading businesses based in the UK. Shell and BP sit alongside the likes of America’s Exxon and Russia’s Gazprom amongst the world’s top oil companies. Products like Ventolin and Nicorette have also turned GlaxoSmithKline and AstraZeneca into two of the biggest pharmaceutical companies on the planet. And whilst there might not be much mining going on in the UK these days, the likes of Rio Tinto and BHP Billiton are still digging up raw materials across the globe.
What these businesses have in common is that they’re global names with worldwide operations and exposure. However, this very strength can also be a weakness. Such is the dominance of the UK’s leading companies that, according to the Capita UK Dividend Monitor, 57% of dividends in 2013 were paid out by just 15 companies. This can constrain fund managers, as looking at the portfolios of even the best UK income funds prompts a feeling of déjà vu, with the same companies cropping up again and again. This can be a risk - holding five different UK funds at the time of the 2010 Gulf of Mexico oil spill was no help if they all had large stakes in BP.
This concentration of large companies also pushes income funds towards certain sectors. The UK market is heavily biased to certain industries, and its dividend payers even more so. Just three sectors – oil & gas, consumer goods and financials – account for over half of the UK’s dividends. Again, this can be a risk – despite their defensive reputation, many income funds were hit when the financial crisis hit their bank holdings in 2008.
However, there are ways to reduce these risks – one of which is by investing internationally. Over the last decade dividends have spread around the world, and data provider Datastream lists 2,108 companies worldwide that pay out a yield of more than 3%, less than 10% of which are based in the UK. Almost half of these companies are based in Asia and emerging markets, and another quarter have headquarters in Europe. Even US companies are now belatedly joining the dividend party.
The fund industry has reacted, with a wave of fund launches taking advantage of the income opportunities available overseas. The bulk of these are global income funds, but an increasing number of regional options are available – particularly in Europe and Asia.
A look amongst the world’s largest dividend payers shows the variety of opportunities available. The world’s top dividend payers in 2013 included Switzerland’s food and drink manufacturer Nestle, China Mobile, and US pharmaceutical giant Pfizer, the maker of Viagra. Even Apple introduced a dividend in 2012 after years of resistance, though it remains a huge hoarder of cash.
Like their UK counterparts, overseas income funds generally favour large, multinational companies. However, most also have a “hometown bias” towards their domestic economies. This has provided a tailwind to European income funds during the Eurozone’s seemingly endless troubles, but at the same time US funds have benefited as their domestic economy has led the world out of the economic crisis. Importantly for investors, this means international income funds can provide valuable diversification.
Probably the biggest diversifier is Japan – for all the talk of globalisation, the country still marches to a very different beat to the rest of the world. Japan hasn’t historically been known for its dividends, but they are spreading gradually as companies learn to become more shareholder-friendly.
Not only can global income funds invest in different countries, they can also access different industries. For instance, the technology sector makes up less than 2% of the UK stockmarket and barely features in UK income funds, but on a global level it’s a different story. Companies like Microsoft and Intel have been around for decades and churn out huge amounts of cash, some of which is now being returned to shareholders as both are mainstays of US and global income funds.
Income from smaller companies
With all the benefits obtained by investing internationally, it’s easy to forget that sometimes even better diversification can be obtained closer to home. Most global income funds invest in large, global companies, so they still maintain a significant degree of correlation to their UK counterparts. Exxon might be based on a different continent to Shell, but in practice both companies operate worldwide and are sensitive to the price of oil.
FTSE 100 companies derive on average just 30% of their revenues from the UK economy, compared to around 50% for the FTSE 250. FTSE Small Cap companies are around 60% domestic, and as a result they tend to perform in very different ways.
Smaller companies pay out a relatively minor share of UK dividends in terms of cash – just 11% of UK dividends come from outside the FTSE 100. Average yield levels are also lower – the FTSE 250 yields 2.6%, the FTSE Small Cap 2.4%, and for AiM it’s less than 1%. This makes it easy to see why this part of the market was ignored for so long.
However, if we look at numbers of companies it’s a different story. There are over 200 dividend-paying companies in the FTSE 250, plus almost 400 small cap and AiM companies. There are simply more opportunities further down the market cap scale.
These opportunities are often found in different business areas to those favoured by larger companies, though that doesn’t necessarily mean they’re unfamiliar. For example the three-star rated Unicorn UK Income fund, which is just one of a thriving sub-sector of small cap and multi cap income funds, includes cinema operator Cineworld and brewer Marston’s on its portfolio.
These funds have proven to be much stronger performers than large cap funds in recent years. However, this might not always be the case as smaller companies tend to be higher risk and more volatile. Dividend paying stocks typically provide some protection from falling markets, but regardless small cap income funds were still hard hit in 2008.
No one fund provides the answer for equity income investors. But by using a range of income funds you can diversify your portfolio across different companies, different regions and different industries. This could help maximise your chances of achieving a growing income.
For the opportunity to invest in equity income funds, download our Premier Selection guide.
The value of investments, and the income derived, can go down as well as up, and you can get back less than you originally invested. Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should ensure that you understand the nature of any fund before you invest in it. Smaller companies shares can be more volatile and less liquid than larger company shares, so smaller companies funds can carry more risk. This article does not constitute personal advice.