The outlook for UK equity income

Will investors looking for profits turn once again to equity income?

The UK stock market is well known for providing investors with plenty of income through the issuance of dividends. But as growth stocks have boomed over the past decade, much investor focus has been on these rapidly growing companies and less on the high dividend payers.

However, as growth stocks achieve such weighty valuations, with questions over how much further they are likely to grow, attention has turned once again to the dividend payers as investors look for areas to make profits.

Big dividend payers tend to be more traditional areas of the stock market – energy, commodities and banking. Some of these businesses, notably in banking, have undergone a period of restructuring and built up their balance sheets so that prospects for paying dividends look more sustainable.

This report looks at some of these issues and is worth an indicative 30 minutes' CPD.

Raising exposure to equities

A slight majority of FTAdviser readers have raised exposure to UK equity income, according to a February poll.

Nearly six in 10 (57 per cent) said they had increased their clients’ exposure to UK equity income funds over the past year, while more than four in 10 (43 per cent) said they had not.

Outflows from UK equity funds reached a record £5.3bn last year, according to the Investment Association.

The previous record was £4.9bn in 2016, when the UK voted to leave the EU, the trade body notes.

But there are signs of a change in attitudes towards UK equities.

In January JO Hambro Capital Management announced that it had re-opened the JOHCM UK Dynamic fund and the JOHCM UK Equity Income fund.

The active asset manager said the decision was a result of the “high conviction we have in our processes in the current market environment and our positive outlook for the asset class following a multi-year period of redemptions in UK equities”.

Both funds had only been available to existing investors after ‘soft closures’ in 2019 and 2013 respectively.

Last month fund manager Nick Train also said that the backdrop for investing in equities remained “hugely encouraging” in a letter to shareholders of the Lindsell Train UK Equity Fund.

Market sentiment shifting

Advisers tasked with the creation of income portfolios for clients have, for a decade or more, faced the dilemma of record low bond yields and relatively low equity yields as a result of a combination of sluggish economic growth and buoyant equity markets.

The sluggish growth in the wider economy meant investors were focused on assets that perform well when interest rates are low, so-called 'long duration' equities, also known as growth stocks.

The performance of these equities is linked to interest rates because the market expects those companies to earn far more substantial returns in future than presently.

When interest rates are low, people are happy to buy shares in companies that are growing quickly (such as tech shares) because those companies will make profits in the future, rather than now. Waiting for the future profits is less of a sacrifice when interest rates are low, because the alternative is to hold cash or bonds, which are paying a low return.

However, in a world of high rates, people do not want to own shares that will make money in the future, because they can get more from cash, so that means they buy the shares of companies that make their money now, such as miners.

Such low interest rate market conditions have been particularly painful for UK equity income investors as they require income now rather than in the future. 

But by investing in the shares of the dividend payers, they have had to effectively sacrifice the gains made by the growth stocks, in areas such as technology. 

However, the advent of higher inflation and higher interest rates has meant, since the start of 2022, market sentiment has shifted, with long-duration equities in areas such as technology selling off, and the more value type equities in areas such as mining rising in value.

This has changed the outlook for income investors, as they may be able to achieve both capital growth and a reliable income.  

The FTSE 100 has just four tech stocks at the time of writing, but is replete with companies in areas such as mining, oil, and banking, which would be expected to benefit from this shift in market sentiment. 

ESG has actually helped the oil stocks
Tom Moore, Abrdn

Those three sectors account for 40 per cent of the dividends in the UK market right now, according to Tom Moore, who runs the £681mn UK Income Unconstrained Equity fund at Abrdn.

Ian Lance, who runs the £941m Temple Bar investment trust, says: "After many years of strong stock market gains, investors had come to believe that they no longer needed income as they could just harness their capital gains each year.

"Given the record-high valuations in many equity markets, we believe this will no longer be the case and that investors will revert to seeking dividend income. Fortunately the UK market provides lots of opportunities to do this.” 

Sustainable income? 

Many market participants have been wary of investing in those very sectors in recent years due to concerns about the impact of environmental, social and governance factors on their business models, as well as potential technological disruption and regulation. 

But Moore says the recent strong performance of many of the shares in those sectors in recent weeks has not just been about the rotation in markets towards more value-oriented stocks; he says bigger factors are at play, which should boost the long-term income potential of those sectors, which comprise such a large part of the market. 

He says: “ESG has actually helped the oil stocks. For a few years there has been under investment, so supply has been constrained, but what we have seen lately is that, in the UK, fossil fuels are still part of the energy mix, renewable energy is not yet enough. So we have a situation where supply has been constrained, but demand has been stronger than expected, and that is obviously very favourable for the shares and the dividends.”

Of the miners, he notes that the growth of the electric car market is likely to mean demand is strong in future years.

With regard to banks, he says “the era of cheap or free money [via quantitative easing or low interest rates] means that some of the loss-making fintech-type companies that have competed with banks in recent years will struggle. But in addition to that, higher interest rates allow banks to earn more money.”

This happens because banks are required by regulators to retain a portion of their balance sheet assets, typically around 14 per cent, in liquid assets such as cash or bonds. 

I find there are more income opportunities among the small and mid-cap companies
Chris McVey, Octopus

For much of the past decade, low interest rates and bond yields meant banks earned little return from these vast pools of capital; as both of those things rise, so does the interest banks receive. 

Moore says the three factors outlined above will be long-lasting, rather than simply a function of a shorter-term shift in market sentiment. 

Lance says: “These sectors are no longer ‘beaten up’, with the energy sector being the best-performing sector both year to date and over the past 12 months, albeit still down significantly over the past decade.

“Secondly, ESG and regulatory concerns have created an opportunity in energy. As many fund managers took a decision not to invest in the sector, the selling pressure pushed share prices down until the sector became very attractively valued.

“In addition, the industry has reduced capital expenditure by 50 per cent since 2013 and created the situation whereby there is insufficient supply to meet growing demand and this has led to record-high prices for natural gas as well as oil prices rebounding. At these levels, the integrated energy companies will produce huge amounts of cash with which to pay dividends and buy back shares even after their investment in renewables.”

He adds: “Banks have undergone a lot of change over the past 10 or 15 years, and for parts of that their balance sheets were not in a position to protect the dividends they pay to shareholders. But the restructuring has now happened, they have taken the costs and they have spent money on updating software systems, but they paid for that by selling some of the businesses they own, and as a result now are in a position where the dividends look more durable.” 

Ken Wotton, who runs the Multi-Cap Income fund at Gresham House, tends not to want to own mining and oil companies in his funds.

He says: “The dividend outlook for those types of companies is very dependent on macro factors such as commodity prices and oil prices, and I am not really qualified to make those calls.” 

Expensive habit

The current yield on the FTSE 100 is 3.5 per cent, which is below the long-term average for the market. 

Although the FTSE 100 outperformed the US market in January, the gains came from just four sectors, the three mentioned above, plus tobacco.

So, has the recent rally in income stocks reduced the opportunity set for clients? 

Simon Young, UK equity income fund manager at Axa Investment Management, says: “It probably has come down for income investors a bit lately. I know some market participants who say that income managers just buy companies for the dividend and nothing else, but I have never actually encountered a fund manager who says they do that. I am quite happy for a company to say that rather than pay a higher dividend, they will invest the cash for growth instead.” 

Young’s fund actually changed its name (previously having 'blue chip' in the title) as he felt some of the companies that have been labelled blue chip in the UK are no longer attractive investments, citing Vodafone as an example. 

He feels such companies, while they pay a reasonable dividend, may not have the potential for growth in the future.

Simon Gergel, who runs the Merchants Trust, says he has been finding fewer income opportunities among the large cap UK stocks, “and about the same number as always” among the mid-cap stocks, and has increasingly been investing outside of the UK in search of new opportunities.  

Chris McVey, who runs the Octopus Multi-Cap Income fund, says the issue with the UK large cap market is the concentration of dividends in a small number of stocks, “and I find there are more income opportunities among the small and mid-cap companies.”

Tim Marshall, UK equity fund manager at Invesco, says: "The FTSE 250 tends to outperform against the FTSE 100 around 66 per cent of the time, but during the recent market turbulence, the small and mid-cap index is in sharply negative territory, while the FTSE 100 has made gains."

Moore says this is because the market is worried that smaller companies have less capacity to protect themselves from higher costs than larger companies and so may have less capacity to keep paying dividends. 

There is no perfect investment vehicle
James Burns, Smith and Williamson

Simon Moon, who jointly runs the Unicorn UK Income fund, which tends to shun the large caps for income and instead buy mid and small-cap companies, says there is a “resilience” to the income in smaller companies as it is more often the case that those companies have significant family shareholders, who are more likely to rely on the dividend for their own income than salaried business executives who are not major shareholders.

McVey says many of the largest companies in the UK market, for example Shell and BP, were “overpaying”, that is, having dividends that were unsustainable. He feels the pandemic allowed those companies to cut their dividends to more rational levels, and investors should expect this to be the normal level in future.   


A feature of the market over the past decade has been the rise of alternative income investments, in areas such as music royalties and aircraft leasing, as investors move away from low bond yields. 

There are multiple challenges for an adviser seeking to allocate to these types of assets. The first is that while the underlying revenue streams of those types of companies are likely not to be correlated to wider economic conditions, those assets are relatively new, and there is not numerous years of data for investors to examine on their performance.

In addition, when considering the diversification potential, while the underlying income stream may not be linked to the wider economy, the investment vehicles in which these are held are listed on the stock exchange, so one would still be exposed to the usual equity market risk. 

James Barton, chief executive at Featherstone Investment Management, is keen on such assets to the extent that they have replaced any bond allocation in client portfolios. 

James Burns, who runs the model portfolio service at Smith and Williamson, says alternative income investment trusts in areas such as student property are attractive right now, but carry the same sort of volatility levels as do wider equity markets, demonstrating that there is “no perfect investment vehicle.” 

Is the UK really paying too much in dividends?

London is becoming the Jurassic Park of stock exchanges, it was claimed recently.

The blame was pointed at UK equity income funds that – summarising loosely – encourage British companies to pay out too much in dividends and not to prioritise sufficient investment in future growth.

Recent market moves might prompt questions about the effectiveness with which numerous still-unprofitable US tech growth stocks have used funds raised by investors.

However, there is no doubt that UK stocks in aggregate have struggled. The FTSE All-Share has lagged the MSCI All Country World Index by nearly 40 per cent over five years.

How much is that down to other matters – not least Brexit ­– and how much to being overly generous with dividends?

Comparing markets globally for their cash return characteristics is harder than it may sound. Take banks, for instance. US banks may pay lower dividends in yield terms, but they tend to buy back more shares, which they then cancel.

The lower share count in turn drives dividend per share growth. You must look at total cash return for the full picture. An added complication is that British and European banks were not allowed to pay dividends during the Covid-19 crisis and are now playing catch up as the regulators loosen cash return restrictions.

Many European banks made unnecessarily large provision for defaults and can now offer generous windfall payouts and share buybacks that their US counterparts will struggle to match. This year we expect Barclays, HSBC and NatWest to deliver dividend yields in excess of 3 per cent.

You can find Eurozone banks redistributing much more in the form of dividends. BNP Paribas looks like it will be kicking out almost 6 per cent in May this year, with ample ability to buy back a large chunk of its market cap in coming years – which is why we hold it in the Artemis Global Income fund.

A classic strong dividend payer is the commodities sector. It also relies heavily on reinvestment – mining companies must continue discovering and developing new seams of opportunity. There are no super-miners like Glencore, Rio Tinto or Anglo in Europe. The nearest equivalent in developed markets is America’s Freeport-McMoRan.

To get an idea of how much of its profits a company is reinvesting, look not just at dividends paid out but how that compares with its overall free cash flow yield.

Glencore is on a forward dividend yield of 5 per cent and a free cash flow yield of 18 per cent, which compares with 1 per cent and 11 per cent for Freeport. Glencore is attractively rated because it has not disposed of its coal business yet. Its ESG scores suffer as a consequence, but it is fast improving and could be re-rated – which is why we hold it.

And what about oil and gas? With oil at $90-$95 (£66-£69) a barrel, the industry is enjoying a bonanza, but it may be one of the last. Companies have to decide how much to invest in the transition to a low-carbon world. By our estimates, it is Britain’s Shell and BP that are investing most to secure a long-term future. Whether they can achieve that profitably and are the best stocks in the sector to hold today is another question.

Academic research and experience teach us that the highest dividends payers tend to be companies in distress and value traps, or companies not investing for the future. This brief excursion into the data illustrates how complex the numbers are and why investors need to look beyond headline dividends. It shows that the story is nuanced from industry to industry.

Arguably, much of the underperformance of the UK versus US can be explained by the different sector mix. How well would the S&P 500 have fared if it consisted of high-dividend-paying Verizon, Altria, Pfizer, Freeport, Citigroup and Exxon and not of FANGs and quality growth names? Apple, Microsoft, Amazon and Alphabet alone make up more than 12 per cent of the world index, while their dividend yields are close to zero in aggregate.

There is truth in some of the criticisms levelled at the UK, though. British companies have traditionally been higher dividend payers, and boards have wanted to appease the market with a progressive dividend strategy.

Coming from a high base, a progressive dividend per share through the cycle can be problematic, leaving companies unable to meet all demands for excess cash.

American companies like a progressive, rising dividend strategy, too, but they tend to be coming from a lower base. And, as we have seen, they buy back stock.

This means the dividend per share rises, though the pool of money they pay out does not. It is a smart marketing strategy, signalling more measured capital allocation. Financial markets like it.

American companies also tend to pay quarterly dividends. The UK favours twice-yearly and Europe annually. Quarterly dividends smooth the income and make it easier for me, as a fund manager, to time exit decisions.

Europe’s reluctance to follow a progressive dividend approach does not help its market. A German industrial may pay a high yield in percentage terms one year and nothing the next. You must hold onto the stock for that one day of the year when there is a payout – which can be a mug’s game, because the share price often falls more than the dividend in the following weeks as income investors pocket the distribution and sell the stock.

This all demonstrates how hard it is to plan a global income strategy and how much more savvy US companies are in the way they give back cash. Corporate boards in the UK – and Europe – could learn from them.

Market participants tend to favour combining a progressive low-base dividend with a share buyback to absorb cash in abnormally profitable years. 

As for me, wherever I look to invest I think about total return – it is foolish to look at dividend yields in isolation. Capital growth, a sustainable dividend yield and dividend growth are the holy trinity.

Though it is not easy to navigate the complexities and nuances of international markets, I can find enough of these companies to build a well-diversified and global portfolio.

Jacob de Tusch-Lec is manager of the Artemis Global Income Fund

All photos via Unsplash

All photos via Unsplash