Investors need to look through the headline yield and focus on companies that are stable and have strong cashflow and dividend growth, according to Premier Asset Management’s Chris White.
He said when it comes to income the dividend is the “icing on the cake” rather than the cake itself, meaning that total returns and good fundamentals are just as important.
White manages the £236m Premier Monthly Income fund, which has been a top quartile performer since White took charge in 2010.
Indeed, over the period it has returned 103.9 per cent, 19.2 percentage points ahead of the IA UK Equity Income sector and 31.1 percentage points ahead of the FTSE All Share benchmark.
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
“High dividend yields can be a risk and if you just invested on the basis of a company’s dividend yield you would probably have disastrous investment performance,” White said.
Despite a high headline dividend yield on the fund of 4.22 per cent, the manager said he is not just looking for upside on stocks: he tries to protect on downside risk as well.
“We try and protect on downside risk by finding these companies that are stable, have this strong cashflow and strong dividends because if we are picking a company that yields 6 per cent and the shares fall 10 per cent they are still yielding 6.6 per cent,” he said.
The scourge of income managers are companies that cut their dividends, something White said he actively tries to avoid, selling positions last year despite high yields.
“I’m very careful about trying to avoid dividend cuts when it comes to investing: last year I sold out of a few stocks because I wasn’t convinced they were going to have the ability to maintain their dividends,” he explained.
“So, we sold out of companies like Vodafone, SSE and Centrica where we just started to feel a little bit nervous about their ability to continue to sustain their dividends because dividend cover was low.
“Balance sheets were looking a bit stretched and there was regulatory concern with regard to Centrica and SSE where if tougher regulation had been introduced then the ability of those companies to maintain their dividends was much reduced.”
Instead, he said he focuses on “boring” companies that have been mispriced but have the potential for handsome returns in the medium term.
“Our classic investment would be a company that trades on let’s say a price-to-earnings (P/E) ratio of 10 times, has 5 per cent earnings growth, a dividend yield of 5 per cent and has dividend growth at 5 per cent,” White noted.
“A lot of people might think that is boring but if we can buy those sorts of businesses and we have an angle on them and can see why they might re-rate to 13-14 times earnings then we can get a return of 30 to 40 per cent just on that re-rating of the equity.”
The latest example of a company with these characteristics is recently-listed Strix Group, which came to market last month.
“One of the nice things about being a multi-cap investor is that we can find a lot of these companies further down the cap scale where people aren’t looking so much,” the manager said.
“The thing about the equity income sector at the moment is that the income isn’t in all of the obvious places.
“Where equity income managers have previously loved to fish in consumer staples, pharmaceuticals, utilities and a lot of those sectors you would class as bond proxies.”
These sectors have outperformed strongly over the last few years, he noted, but are now trading at extremely expensive valuations giving them heightened risk compared to other opportunities.
“Strix is a global leader in kettle systems that came to the market on a P/E of eight times and a dividend yield of 7 per cent. It got floated at £1 and is trading today at 135p,” White said.
“We think the shares today are worth 180p without stretching our investment case too much and that would only put the company on a P/E of 12 and a dividend yield of 4 per cent. It just gives you an idea of how on the re-rating argument we can buy a stock on 10 times and it can re-rate to 13-14 times.”
The other area the manager is backing is the oil stocks, despite many fearful that the dividends may be cut if the oil price were to plummet further.
“The biggest debating point in our portfolio in terms of dividend yields is with regard to the oil stocks because companies like BP and Shell have optically got high dividends,” White said.
Performance of sectors over 5yrs
Source: FE Analytics
Indeed, both stocks have lagged the wider FTSE All Share over the last five years as the Brent crude spot price has fallen 64.82 per cent, plummeting from more than $100 per barrel to as low as $30 per barrel before settling around $50 per barrel more recently.
“Over the last few years, the oil price has been very volatile and bottomed out at $30 per barrel and clearly if the oil price was still at $30 those companies’ dividends would be under a serious amount of pressure,” the manager noted.
“We have had quite a strong view about the oil price and believe that the oil price is likely to be in a $50-$70 range over the next year or two.”
White explained that this is due to the Saudi Arabian government, which is intending to bring the oil market under control ahead of the widely-anticipated market floatation of Saudi Aramco – the state-owned oil company.
“We have got a strong view that Saudi Arabia wants to keep the oil price up above $50 for a few reasons but mainly because they’d much rather float it [Aramco] with an oil price above $50 than below $50,” he said.
“Our view of the oil price therefore has led us to invest in those stocks on the basis that they are still quite cheap and their dividends are attractive.
“The way that I look at those businesses – they both yield around 7 per cent but if Shell was trading at £30 it would have a yield of 5 per cent and if BP was trading at £6 it would have a yield of 5 per cent. So we feel that that is reasonable [share price cover].
“And if the oil price does improve, which we think it will as the supply/demand balance improves, then those companies will have dividends that are sustainable and may possibly at some point start growing again.”