Multi cap approach could pay greater dividends for UK equity income

Investors looking to diversify their portfolio shouldn’t put all their eggs in the biggest baskets. 

The UK equity income sector has had a long-standing problem with concentration, with ten ‘mega cap’ FTSE 100 companies making up 53% of all UK dividends. 

Many traditional UK equity income funds have substantial weightings within these same stocks too. So even if you diversify exposure across several of these funds, chances are you’ll remain heavily exposed to the same larger holdings.

Source: Octopus & Lipper, 31 May 2020

This means massive asset correlation across UK equity funds and asset concentration issues  for investors who end up over exposed to a relatively small number of companies. 

Given the effects of the coronavirus pandemic on the UK economy, the concentration risk associated with these holdings has become more apparent, making the need for diversification that much greater. 

Fortunately, there’s a simple way to diversify your exposure while targeting a sustainable and growing equity income stream. And it can more than hold its own against the more traditional approach. 

High paying dividends aren’t being matched by earnings 

Large companies in the market are popular with investors because they pay out a lot in dividends. The people running these companies also know many of their investors hold shares specifically for the dividend, meaning they’re mindful of maintaining and growing it a little each year. 

And while the average dividend per share growth has been strong for the mega caps over the last ten years at more than 9%, the average earnings per share growth for the same companies over this period has been a meagre 0.3%. 

What’s more, if we look at the average dividend cover for those 10 most popular holdings over the past decade, the average cover of over 4x back in 2010 rests in the region of 1.5x today, primarily because these attractive payouts haven’t been sustainable. 

Source: Lipper to 31/12/19

When we add coronavirus to the mix, what we saw as an emerging trend of curtailing dividends has now been accelerated significantly. 

Take Shell and HSBC, for example. They’re expected to cut their dividend payouts by 25% and 44% respectively this year. This is, of course, a steeper drop than what would have been expected without the pandemic, but many big holdings are likely to see their dividends subdued for quite some time as they recover from the crisis. 

For investors heavily exposed to the mega caps, it means their income stream is being negatively impacted by a lack of underlying earnings growth. This is a real concern, but it’s one that could be mitigated. 

Finding the sweet spot 

Of course, there’s no hard and fast rule, but we believe the greatest opportunity within the market, then, seems to lie within this sweet spot of dividend growth and earnings growth. The small, mid-cap space (above 100m, but below 1bn) where a lot of companies are on a steady growth trajectory. 

That’s where taking a multi cap approach comes into play. 

By looking across the wider market, and not just concentrating on the ten traditional companies, investors can target a sustainable equity income stream that’s more than capable of growth. This approach could compliment a portfolio where there are already holdings in those mega caps. 

However,  investors will need to be comfortable with the additional risk that come with investing in smaller companies than those listed on the main markets

 FP Octopus UK Multi Cap Income Fund

This fund isn’t constrained by investing in any one part of the market. Instead, we look to assess each holding on three key characteristics:

• the ability to deliver a dividend yield in excess of the wider market,
• the ability to deliver faster than market earnings growth, and;
• the ability to deliver faster than market dividend growth.

This differentiated, multi cap approach gives us the opportunity to buy potential equity income stars of the future, before many more traditional income funds would consider them – whilst also holding more traditional dividend-paying stocks.

While consensus estimates are likely to see some further adjustments given the uncertain economic outlook, the predicted weighted average dividend cover across the Octopus UK Multi Cap Income Fund is currently over 3x for 2021. 

This is actually an increase from pre-covid levels of around 2.3x, although there have been a number of dividend cuts across the portfolio since then. 

Nonetheless, the increased level of cover across the Fund gives us confidence that many of our holdings remain well positioned to reinstate dividends in the relatively near term, and to grow their dividends pay-outs going forward. 

To put things in perspective, the same consensus data for the ten largest dividend payers within the UK market estimates an average cover in the region of 1.42x for 2021, despite the well flagged dividend cuts.

Risks to bear in mind

The value of an investment can fall or rise and you may not get back the full amount you invest. Smaller company shares are also likely to fall and rise in value more than shares in larger, more established companies listed on the main market of the London Stock Exchange. They may also be harder to sell. 

Growth and income potential 

Within the Octopus Multi Cap Fund, we have a strong portfolio of companies that we believe lie on this 3-5 year steady trajectory of matched dividend growth and underlying earnings. Please remember that the mention of stocks is for illustrative purposes only and should not be seen as an investment recommendation. 

Here’s a closer look at some of them: 

• Strix Group Plc – £380m market cap

The global leader in kettle safety control technology with over 50% market share. Strix management paid its final 5.1p dividend in May, and on a prospective basis for the year to December 2021, the stock is expected to pay a healthy 4.3% dividend yield at current levels, with the Dividend per Share pay-out expected to grow by c4% on the previous year.

• Emis Group plc – £670m market cap

EMIS is a leading UK provider of IT software and systems for the healthcare industry, and importantly right now, for the NHS. With approximately 80% recurring revenues, and a balance sheet with over £40m net cash, the group paid its final 15.6p dividend last month.

At current levels, the group is expected to deliver an attractive prospective yield of 3.3% for the year to December 2021, with the Dividend Per Share pay-out expected to grow by c6.2% on the year to December 2020.

• Spirent Communication – £1.4bn market cap

Spirent is a leading technology and testing provider for the communications sector. The prospective dividend for the year to December 2021 is about 2.1%, however the Dividend Per Share pay-out is expected to show a healthy year on year increase of over 11% versus December 2020. 

In 2019, the FP Octopus UK Multi Cap Income Fund outperformed every other fund in the IA UK Equity Income sector, in its first full year since launch, on a total return basis. 

Discrete yearly performance to June 30 quarter end (%)

Past performance is not a reliable indicator of future results. Source: Lipper to 30/06/20. Returns are based on published dealing prices, single price mid to mid with net income reinvested, net of fees, in sterling. The FP Octopus UK Multi Cap Income launched on 10/12/18. 

Our investments are not suitable for everyone. We do not offer investment or tax advice. Personal opinions may change and should not be seen as advice or a recommendation.

Before investing you should read the Prospectus, the Key Investor Information Document (KIID) and the Supplementary Information Document (SID) as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The Prospectus, KIID and application forms are available in English at octopusinvestments.com. The Authorised Corporate Director (ACD) of these funds is FundRock Partners Ltd which is authorised and regulated by the Financial Conduct Authority no. 469278, Registered Office: 8/9 Lovat Lane, London EC3R 8DW. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London EC1N 2HT. Registered in England and Wales No. 03942880.CAM009943.