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The income risk investors need to be aware of · On The Money

• 0:03
  Kyle Caldwell: Hello, and welcome to On The Money, a weekly look how to get the best out of your savings and investments. In this episode, we're gonna be focusing on concentration risk within The UK equity income market, examining whether it is a big problem for investors. Joining me to discuss this topic is Eric Moore, full manager of the Slater Income Fund. So, Eric, before I put the questions to you, I'll just firstly set the scene. So if you're an income seeking investor, The UK stock market is a very good place to look.
• 0:35
  It has a rich dividend heritage, and the market also typically offers an attractive yield, a higher yield than most of the markets. At the moment, it's around 3.6% for the FTSE one hundred index. However, an important thing to bear in mind is the highly concentrated nature of UK dividends. The biggest companies dominate. For example, in the first three months of this year, the top 15 dividend payers accounted for just over 80% of all income payouts, and that's according to Computershare.
• 1:09
  The top five payers accounted for just over half of all UK dividends, and those five companies were AstraZeneca, Shell, British American Tobacco, BP, and Unilever. Now when it comes to UK equity income funds, it is fairly common to see many of these big income heavyweights in the top 10 holdings. So, Eric, to start off, could you explain how much of an issue concentration risk is for income seeking investors backing The UK market?
• 1:41
  Eric Moore: Great question. Well, thank you, Kyle. So it is an issue. I think if you look at any one quarter, obviously, it's slightly skewed by who's paying now. But it you're right.
• 1:50
  Even over a whole year, which takes out some of the some of the lumps, probably about 12 to 15 stocks make up about half the market total income in terms of pounds. And, actually, it's kind of been ever thus. So I've been doing this for a while, and it's pretty much always been that way. Now the reason for it, though, is you we've got some big companies that also have big dividend payers, but it's not actually just an income issue. Some of these actually, if you just looked at the market capitalization of these companies like Shell and BP, British American Tobacco, the companies you mentioned, they also dominate the capital side of the index.
• 2:24
  So they're just the biggest companies. So if you looked at the the weight of stocks within the index, probably about 15 stocks are typically half the market in terms of capitalization. So even if you owned a tracker fund and you think you're massively diverse, so you're not particularly thinking about income or anything like that, you're just thinking, oh, we've got diverse play on The UK stock market. Actually, half your money is gonna be in about 15 stocks. So it's a feature of The UK stock market rather than necessarily a feature of the income category, if you're with me.
• 2:49
  Kyle Caldwell: And when you're constructing a portfolio, I'm assuming you're very conscious of who the big dividend payers are. I can see in your top 10 holdings, you do have some exposure to them. You've got Shell, which is your top holding. You also have BP lower down in the top 10.
• 3:05
  Eric Moore: That's right. So the Slater Income Fund is is what we call all caps. So we have some FTSE stocks. We have some mid cap, some small cap, and some and some AIM stocks. So we get around this problem of concentration of both the benchmark and and where the income is coming from by investing across the capitalization ranges.
• 3:21
  So big, medium, and small. So we have some big ones, as you pointed out, like we have Shell, which has a it doesn't have a supersonic yield, but yields about fallen a bit and has ambitions to grow their dividend by 5% per annum, which we think is a pretty attractive blend of good and growing income, which is what we're after. But there's also you know, there's quite a some of the bigger yielding stocks in the in the market that we have avoided. So we don't own British American tobacco, for instance. We don't own HSBC, which is one of the biggest yielding stocks in the market as well.
• 3:49
  So we think there's plenty of stocks out there with good, you know, good attractive income characteristics that we can maneuver away beyond the top ones.
• 3:58
  Kyle Caldwell: So overall, you hold less than the index in, say, the top 15 dividend paying companies?
• 4:03
  Eric Moore: That that would be correct. Yeah. So even where we have Shell, we probably don't have as much as it represents in the index, and we will be you know, we've we've got nothing really wrong with the the FTSE one hundred, but what we're trying to find is companies with a good yield that are also growing, and it tends to be some of those companies in the towards, you know, the very big companies, it's the growth bit that they will find quite hard to deliver for us.
• 4:22
  Kyle Caldwell: So by focusing on companies of all different sizes, this is the way that you try and navigate concentration risk?
• 4:29
  Eric Moore: That's right. And the portfolio itself is we've got 45 stocks, which we think is a nice nice number. So it's it's concentrated enough that everything there is pulling its weight, and we don't have a sort of a rag rag bag and a sort of a bit of a tail, but also it's enough to to provide decent diversification. Yeah.
• 4:45
  Kyle Caldwell: What's the current split between large, mid caps, and small caps?
• 4:49
  Eric Moore: So very roughly, we have about just under forty percent four zero in small cap and AIM together, and then we'll have a bit less than 20% in mid caps, and then what whatever that leaves us sort of about 40% ish in the FTSE 100 stocks. And, you know, we don't use those as targets, but that's kind of how the portfolio has been for the last three years or so. So it's been pretty consistent.
• 5:11
  Kyle Caldwell: And why do you think it is that so many full managers levitate towards the biggest payers? Is it because they mainly focus on larger companies and also to be a fear of underperforming the index drastically by being so differently from it?
• 5:24
  Eric Moore: Yeah. There's there's a bit of that, I think. So we we are very benchmark agnostic if you like. So, you know, we're aware there's an index out there. We know we'll we'll be compared to it and understand that.
• 5:34
  But when we come to how we think about the stocks we wanna have in the fund, we don't really think about or what their shape is in the index or or indeed what other, you know, what other people are doing. So we judge each stock more in its own individual merits, perhaps more with a sort absolute return mindset that we wanna buy shares that are cheap on an absolute basis. And we're not afraid to own you know, to not own big stocks. So for example, AstraZeneca is the biggest stock in the index by I'm not even sure how much it is, but it's a it's a big old big old unit. And we, you know, we we're happy not to own a share in that.
• 6:05
  So we think that, you know, the market there's lots of stocks beyond these sort of obvious, you know, hunting grounds. And I think we we also benefit from you know, the the fund is actually is is relatively small, so that makes it easier. So, you know, these very some of the big funds that have been very successful, you know, they get to the size where they become quite big, so it gets harder to explore some of these smaller cap situations.
• 6:28
  Kyle Caldwell: And could you talk us through the key characteristics that you like to see in a dividend paying company? You mentioned that you've got a total retain mindset. Does every company have to pay a dividend to be in the fund?
• 6:39
  Eric Moore: It certainly helps. Yeah. So we say, you know, as an income fund, we we kind of think people would expect us to own stocks that are generating a dividend. And, actually, if we own shares that don't any individual shares that don't pay dividend, it just puts a lot of a strain on all the other stocks in the portfolio to have to work harder for it. So I kinda take the view that unless you're yielding, you're probably not for our income fund.
• 7:01
  And we don't put hard and fast rules around it, but broadly speaking, if you yield less than two and a half percent, you're not gonna get me very excited. But we're looking for companies that have a good yield but can grow their dividend, and it's the dividend growth bit that will power the capital side of your equation if you like. So it it's no good just buying companies that have a high yield but aren't gonna grow their dividend because you're just a bond. So if you got companies that yielding six but not growing the dividend, then your total return that is probably gonna be six. So it's not it's not really good enough.
• 7:31
  So you're better off in a company even if it yields a bit less, say, know, know four, but you're growing the dividend at five, six, or 7% in a sustainable way, that should drive a double digit total return. So really simple rule of thumb is something I look at is to say, is the yield plus the forecast dividend growth more than 10%? Then that's a good start. So as I said, yielding four, growing at seven, gets you 11. That's a kind of really simple good first base because it should mean other things being equal, you should get a double digit total return from that.
• 8:01
  And if you compound that for a few years because the dividend growth is sustainable, then we'll all be happy.
• 8:05
  Kyle Caldwell: And could you name some stock examples that they've obviously got a number of them in the portfolio. Perhaps you could mention a a larger company that you have exposure to and then also a smaller company as well.
• 8:16
  Eric Moore: Yep. Sure. So there's a range. So I say everything should be yielding and growing, but there is a bit of a range within that. So we have some stocks that are yielding quite a lot, like legal in general, Nothing that probably yields a thick end of 8% at the moment, but the dividend growth is probably only two or 3% at the moment.
• 8:33
  So that gets you to my sort of double digit number, but it's very much skewed to the yield part. But you're still in that spectrum, and you're still meeting the requirements. In terms of smaller companies that perhaps are a bit more growthy, we bought com shares in Workspace lately, which where we think the dividends should be growing quite strongly. In some of the building material stocks, we like GenuiT. We think the dividend growth this year is not gonna be great, but we expect it to accelerate.
• 8:58
  So everything is contributing both to the yield and to the growth.
• 9:01
  Kyle Caldwell: And how do you assess that the dividend is potentially gonna be sustainable over the medium to long term? There's, of course, always a danger that a company management team overprioritizes a dividend, and, you know, they try and keep shareholders sweet
• 9:17
  Eric Moore: Yeah.
• 9:18
  Kyle Caldwell: Rather than putting that money back into the business.
• 9:20
  Eric Moore: Yeah. Absolutely right. So we talk about sort of good and growing dividends. So you can say, well, what does good mean? And as as I said, probably more than two and a half percent, but also the quality of it.
• 9:30
  So not just the quantity, but is it covered by earnings? Is it covered by cash flow? And also importantly, is it needs to not be threatened by a load of debt on the balance sheet. So we do a lot of that traditional financial analysis to make sure the dividend with the ways with the we're expecting this year is is robust. But it's really important that companies are reinvesting as well and have avenues for growth.
• 9:50
  And, you know, equities are all about growth. Otherwise, as I said, you're just a bond. So we want companies that are retaining earnings and reinvesting, and then we want companies that can can grow. We're not talking about necessarily, you know, curing cancer or AI or bridges to the moon or anything, but we're talking about sustainable growth in that sort of 5% range, but consistently, preferably. And so what will it be about a company that will mean they can do that?
• 10:12
  Well, it'll be some some sort of wind in their sails. So it could be regulatory drivers. It could be gaining market share, which is typically more the case among smaller companies, product innovation. Usually, it does sort of it does sort of coalesce around people with a plan. I mean, it's usually about the management team who understand the business and have got a plan to execute it for the next few years.
• 10:35
  So we meet a lot of companies. We're very bottom up, as you probably should have said before. So we spend a lot of time with companies crunching numbers, meeting people, and we spend relatively little time worrying about the sort of macro stuff about interest rates and inflation, mainly because we don't think we've got any particular claim to get any of that right. But, also, we think it's much more interesting to find if you can find, you know, companies that are a little bit undiscovered, where they've got decent runway for growth and that you can buy and hold for the long term, that's what that's what really excites us.
• 11:05
  Kyle Caldwell: And the Slater Income Funds, at the moment, its yield is just above 5%. Yeah. You mentioned Legal and General earlier as an example of a high yielding stock that you own. Yeah. I assume you'd have to have exposure to a couple of other chunky dividend payers Yeah.
• 11:20
  In order for the fund to yield that much. Yep. Could you explain which ones you hold?
• 11:24
  Eric Moore: Sure. So as I said, there's a range. Everything but we want everything to be yielding and growing, but there's a bit of a a range within that. So some of the higher yielding stocks we've got. So Legal and General, I mentioned.
• 11:34
  M and G, another life insurer slash asset management firm. So that's we've got a very big holding in that. It's one of our biggest positions. And the shares have picked up lately, which is which is gratifying. So, I mean, that that was offering a yield of 10, which is is is kinda crazy.
• 11:50
  And I think it's particularly crazy because I think when you're yielding that much, sometimes it's a red light, not a green light. Right? So the market is saying, watch out. This dividend is not sustainable. But in the case of M and G and also Legal and General, the dividends this year are being generated by business they wrote years ago from the back book.
• 12:08
  So, actually, the dividends are kind of more dependable than many sort of than, say, a manufacturing company or a manufacturing company or a retailer. They're actually some of the more dependable dividends you can see. So I think the dividends are quite attractive. The growth is a tricky bit for those guys because they the back books run off, and they have to replace it with new stuff. So they've always slightly got a bit of a handbrake to their growth.
• 12:27
  So growing the dividend is harder. Other high yield is those or also in financials, we own quite a lot of the smaller fund management companies. So we own Lion Trust, which has been difficult for us, but it has a very big yield, which will probably be cut, by the way. That dividend does look very vulnerable. We own Polar Capital.
• 12:46
  That yields, I think, about 10. And we own Premier Miten, where the dividend yield, I think, is about eight. So these businesses, the fund management companies are very operationally geared. So they're very sensitive to the levels of funds they run, the amount of money they run. And in the short term, the costs are relatively fixed because it's mostly people in buildings and, you know, regulation and, you know, a bit of tech.
• 13:05
  But the the their revenues will wobble around with the amount of money they run, and all of these firms to some to varying degrees have been seeing outflows because it's been a difficult environment. So the dividends cover the amount to which the dividends are covered by earnings has reduced, so the dividends look a bit more squeaky, and hence, you know, the stock market has the shares have been bad on the whole, and that makes the yields look quite elevated. But that can turn, and it can turn quite quickly, you know, so the operational gearing can work both ways. So, you know, if the sum comes out a little bit and and The UK fund management industry starts to see some inflows, heaven forbid, then then the, you know, the picture for those dividends could look, you know, more robust quite quickly. Also importantly, and I mentioned the the significance of debt before as a as a as a thing to worry about when you think about dividends, All these companies have net cash.
• 13:52
  So even if the dividends aren't entirely covered by earnings, they can they can afford to tough it out for a bit, and, certainly, they haven't got the bank manager on the phone breathing down their necks.
• 14:02
  Kyle Caldwell: And in terms of sustainability of a dividend, you mentioned dividend cover. Is it a high concern for you when a dividend cover ratio falls below one times? And are there any other key metrics that you can point to the make you more wary about the the ability of a company to pay a future dividend?
• 14:19
  Eric Moore: Yeah. Absolutely. So if your dividend cover is less than one, that means you you are robbing the balance sheet in some way. So if you've got a load of cash, then perhaps it's okay. But if you are taking on more debt to pay your dividends, then that, you know, that looks tricky.
• 14:33
  And that's the situation that Lime Trust have been in. So they've been paying an uncovered dividend for a little bit. Their approach was, well, the dividend looks uncovered, but on a three year view, it'll probably be covered. And we've got a load of cash on the balance sheet, so we can style it out, which makes some sense. The forecasts have continued to deteriorate.
• 14:51
  So now that, you know, and time has passed and the business is still being in outflows and performance of their funds is not great. So now they look at it and they probably say, oh, even on a three year view, we're not still not covering our dividends by earnings, and the cash pile has gone down a bit because we paid the dividend last year. So it gets hot. You cannot do it forever. Alright?
• 15:10
  So Lime Trust is in some position to keep going. I think, you know, the shares now yield over 20, so it's not gonna be a surprise to anyone when that dividend is cut. In terms of cover, we look at earnings cover from the profit and loss account. We look at cash flow cover, but it will be a bit different business to business. So if you're a very stable business, I mean, a good example would be, you know, Imperial Brands used to be Imperial Tobacco.
• 15:33
  It's a tobacco company, relatively predictable top and bottom line. You can probably afford a bit more debt, and you can probably run with a lower dividend cover if you wanted to than, say, you know, a small engineering company where the profits are very uncertain or more or certainly more volatile, I should say. So it does depend a bit. There's not one magic number.
• 15:52
  Kyle Caldwell: You touched on it earlier, outflows. UK funds, they've been experiencing outflows for several years now, pretty much since the Brexit vote. So what needs to happen for for that to change? And we've seen a lot of money go into global equity income funds. So could you make the case for investors returning to The UK as opposed to going overseas?
• 16:13
  Eric Moore: You're right. There's outflows have been very persistent, and I'm still I sort of surprised there's anyone left to sell it just, you seeing the outflows we've had over the last few years on the Callistone data. It's been been been awful, really, from my of view as a UK investor. And I should say at Slater Investments, we just do UK funds. So what can be done about it?
• 16:32
  I think that I mean, there's various things. There's some government initiatives around. There's some high hopes around the the Mansion House address coming up in July. But, know, these are not within our gift as, you know, as as fund managers. I mean, I think there's lobbying going on.
• 16:45
  I think we've, you know, we've participated in a in a few think pieces around this stuff. But from my point of view, in the trenches, I just need to get on with the day job. From why maybe people should think about The UK is there's you know, one interesting way of looking about it is if you think what's The UK gone through in the last ten years is is being pretty brutal. So, you know, the Brexit referendum, which kinda caught everyone out, to be honest. Then we had will it be hard?
• 17:06
  Will it be soft Brexit? And that whole process got terribly drawn out. Then we had COVID, and, you know, and we've had a sort of revolving door at number 10. So there's there's been a of uncertainty through that process, a lot of reasons for companies and indeed consumers to just sit on their hands. And you've seen that in, you know, lower housing transactions on the consumer side, less big ticket spend, and also lower investment from companies.
• 17:31
  So that sort of ability to plan has just gone out the window really over the last ten years. So with The UK economy has been through these these seismic events. And each time, actually, the economists said, this is a real disaster. We're going to go into recession. And, actually, we haven't.
• 17:46
  So the the economy has been more resilient, and I kinda see the companies I meet. They've, you know, they've all been through the mill as well, and they just want a little bit of peace and quiet. And it could just be that The UK is in the period of relative stability now, and that's and by contrast, the inability to plan and the ability for anyone to make any sensible decisions, the the sort of hot hot spot for that, if you like, is now North America with what's happening in their political situation and indeed, you know, their economic one. So I think perhaps The UK is beginning to look a bit more sensible on a relative basis.
• 18:19
  Kyle Caldwell: Thanks to Eric, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do tell a friend about it. And if you get a chance, leave us a review or a rating in your podcast app too. You can join the conversation, ask questions, tell us what you'd like to talk about via email on otm@ii.co.uk. And in the meantime, you can find more information and practical pointers on how to get the most out of your investments on the Interactive Investor website, ii.co.uk, and I'll see you next week.