How equity income funds have come back into fashion in tricky markets
The market is a pretty grisly place to be right now, as high inflation, rising interest rates, and economic pessimism have taken their toll on sentiment. One area that’s been doing better than most though, is equity income funds, which invest predominantly in dividend-paying shares. As the performance table shows, in 2022 equity income funds have held up a lot better than other areas of the market.
REVERSAL OF FORTUNES
This is a significant reversal of fortunes, especially for the UK Equity Income sector, which has been a real laggard until this year. Returns from the equity income sectors have still been negative this year, but in a falling market, some downside protection is not to be sniffed at, and shallower price falls means these stocks have less ground to make up when sentiment turns. There are also good reasons to believe that equity income funds could be set to come back into fashion, after a long period out in the cold.
Inflation and rising interest rates have made a bird in the hand look more attractive than two in the bush, which favours cash dividends over reinvestment for future growth. If we are entering a period of market falls, or stagnation, some equity income exposure could therefore provide some useful ballast for a portfolio. These funds are by no means exempt from downturns, but they may do better than other areas of the market.
Partly that’s because the immediacy of a dividend provides a bit of a safety net when it comes to valuing a stock, as a cash payment will always set a floor as to what a share is worth. If the market knows a company is going to pay somewhere in the region of a 50p dividend per share, there’s a level below which the stock is unlikely to fall, because that income stream simply becomes too attractive to resist.
RISKS FACING INCOME FUNDS
Dividends can be cut too, and in the current environment where companies face higher debt interest payments, inflationary costs, and a weak economic outlook, dividends could come under pressure.
This is definitely a risk for equity income funds, particularly seeing as many of the big dividend payers are cyclical businesses like mining companies and banks. But the one thing we can say with some certainty about the global economy, is that if it falls backwards, it will recover. The same goes for company earnings, and dividends, which should rise over time.
By contrast, if the lofty valuations on some growth stocks are felled by rising interest rates, there’s nothing to say they will climb back to the same heady heights again. Ultimately, stock valuations tell us what profits investors are willing to accept for investing in shares.
It seems logical to conclude that the reason investors have been willing to accept so much less bang for their buck in recent years is actually because the alternatives, cash and bonds, have been yielding next to nothing. But that tectonic plate is now shifting quite rapidly, and as interest rates rise, the tide is seeping out on growth stock valuations. That tide may not regain its high water mark again, unless we see central banks moving back to near zero interest rates.
PANDEMIC DECIMATED DIVIDENDS
We should also bear in mind that there was a widespread dividend cull when the pandemic hit, as companies sought to cut their cloth to more constrained economic circumstances. This put dividend payments on a more affordable footing. One measure of this is dividend cover, which shows the ratio of company earnings to dividends.
Dividend cover for the FTSE 100 is now at its highest level since 2012. In 2022, dividend cover is forecast by analysts to rise to 2.09 times, compared to an average of 1.5 times in the five years leading up to the pandemic. Clearly analysts can get their numbers wrong, and an economic slowdown means lower earnings, but even allowing for some downward revisions, that’s still a reassuring buffer against swingeing dividend cuts.
Investors can build their own portfolios of dividend-paying stocks, or invest through equity income funds, which provide instant diversification. Investment trusts can be particularly useful for those looking to receive a regular income, as they can smooth dividend payments by building reserves up in the good years to pay out in the bad years.
One of the attractive things about the UK stock market is the level of yield it provides, and there are plenty of domestic fund and trust options available to investors, such as Threadneedle UK Equity Income (B8169Q1) (historic yield 3.1%) or City of London (CTY) trust (yield 4.9%).
While other areas of the global market tend to be lower yielding, investors should consider using them to build some regional diversification into their equity income portfolio, through funds such as Schroder Global Equity Income (BDD2CM9) (yield 3.5%), Blackrock Continental European Income (B3Y7MQ7) (yield 3.2%), or for more adventurous investors, Jupiter Asian Income (BZ2YMT7) (yield 3.8%).
As ever, it’s important not to over-expose your portfolio to one style of investing, but given the relatively lacklustre performance of equity income in recent years, combined with fund outflows from the sector, you might find yourself lacking much of an allocation to these dividend disciples.