Pharmaceuticals, insurance, tobacco and financials are good places to find income on the UK market, says Richard Marwood, co-manager of the £1.7 billion Royal London UK Equity Income Fund (B3M9JJ7).

He believes the prospects for dividends from UK stocks are improving, which should be good news for any investor seeking to generate an income from their portfolio.

Many companies had to cut or suspend dividends in 2020 to preserve cash during the pandemic. Given the vaccine rollout and improved economic prospects in 2021, a lot of these companies are now restarting dividends, and many others who kept paying during the health crisis are now expected to pay even higher dividends.

FUTURE YIELD EXPECTATIONS

The FTSE All-Share yields 2.4% based on payouts for the past 12 months and the index is forecast to yield 2.8% this year, according to Stockopedia. The Royal London fund has a 12-month historic yield of 2.9%.

‘In the last century, a typical yield on the UK market was 5%,’ says Marwood. ‘It’s been a little bit lower since the millennium in part because interest rates have been so low, but I think 3% to 4% seems a reasonable level to expect going forward.’

INVESTMENT GOALS

Marwood’s goal for the Royal London fund is to produce an income greater than the yield on the FTSE All-Share total return index over rolling three-year periods, and to beat the performance of that index. Over the past 10 years, the fund has returned 131.9% versus 82.1% from the FTSE All-Share, according to FE Fundinfo.

Stocks in his portfolio that currently yield more than the market include utilities Severn Trent (SVT) and National Grid (NG.), offering 4.1% and 5.4% prospective yields, based on analyst forecasts.

‘National Grid owns all the pylons that send electricity around the country and it owns the gas distribution network,’ says Marwood, who believes the company will benefit as the UK gradually transitions to reduce the carbon intensity of the energy system.

DIVIDEND SUSTAINABILITY

Sustainability of dividend payments is very important to anyone who relies on income from their investments to pay the bills. Ideally you want a little bit more each year, but certainly not a dividend cut.

Therefore, it is important to pick companies with strong enough finances to keep paying dividends and not have that cash gobbled up by other factors such as ballooning debt repayments or expensive and potentially unrewarding acquisitions.

If you’re not comfortable studying a company’s balance sheet to look at the cash and debt positions, then it might be worth relying on investment funds rather than individual stocks for income as a fund manager would spend time assessing dividend sustainability.

HIGH YIELD DANGERS

Quite often you’ll see a stock where the market doesn’t believe the dividend is sustainable. Investors sell, pulling down the share price and in doing so the dividend yield goes up. For example, if a business is forecast to pay 5p per share in dividends and it trades at 100p then its yield will be 5%. If the market doesn’t believe it can keep paying dividends at that level and the share price falls to 50p, then the yield becomes 10%.

‘Eight out of 10 times a stock on a high yield such as 10% can be a warning sign,’ says Marwood. He believes one exception is British American Tobacco (BATS), currently yielding 8% as the market is worried about its sector coming under regulatory and political pressure and how expectations for sales growth from vaping and other next generation products have been too high.

‘In the case of British American Tobacco, I believe the dividend is sustainable. It is a very cash generative business, paying down its debt quite quickly and it should be able to continue paying (those levels of) dividends,’ says the  fund manager.

Marwood says the time to move on from an income-generating stock is when you lose confidence that the business cannot generate enough cash.

‘A good example in the past is property group Intu. We always looked at how much rent it was collecting. This was stable for a while, but Intu saw problems with retail businesses failing and rent started to fall, so we sold.’ Intu subsequently cut its dividend and ultimately went into administration when its debt burden got out of control.

INCOME OPPORTUNITIES

Royal Dutch Shell (RDSB) is one of Marwood’s biggest holdings in the Royal London fund. The oil producer cut its dividend last year as a way of redirecting cash to help pay for its transition to a greener energy world and because of low oil prices at the time. Even after this cut, at 4.1% it still yields greater than the market and dividends are forecast to grow from here.

He also invests in accounting software provider Sage (SGE). The tech sector is a not a natural place to find income as many tech firms have historically not paid dividends, yet times are changing. ‘I like to spread my sources of income broadly across the market. Sage yields nearly 3% and has a strong balance sheet and repeatable income from subscriptions.’

Another holding which may not initially seem like an income play is spread betting provider IG (IGG), yielding 4.8%. It was a big winner during the pandemic as volatile market conditions drove growth in customer numbers and activity. Analyst forecasts for 2021 and 2022 would suggest ongoing generous dividends, even though revenue is expected to moderate in the latter year.

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