The hunt for income is often a challenge and currently this chase is exposing equity investors, in common with those in some areas of fixed income, to significant levels of asymmetrical risk.
Stocks that are traditionally considered defensive form the bedrock of the equity income investing universe. They are typically very large and mega cap companies characterised by stable, dependable income streams and attractive and often growing dividends. But these stocks are presenting investors with a number of red flags.
Such companies have re-rated upwards again over the past few years as low interest rates have driven investors towards their dividend yield, cash generation, and perceived security compared to more cyclical and more volatile growth-orientated stocks.
The problem is that they are now expensive and their yields far less attractive than in the past. It is becoming ever more apparent that in many cases their share prices are challenged by slowing, and even falling, sales growth, with the knock-on impact on earnings.
The revenues of many equity income fixtures of the FTSE 100 are in fact under significant pressures. Investors in these stocks could be in for a rude and costly awakening amid what can be considered materially negative trends, particularly for those stocks with significant emerging markets exposure.
These businesses are already distributing a high proportion of their earnings. Even in a relatively benign outlook in which they are able to maintain current revenues, they are likely to find it increasingly difficult to continue to grow their dividends above those of the wider market. Even if their share prices do not fall significantly in the near-term – and they could – the prospect of rising interest rates is a damaging one for such bond-proxy stocks.
So what can equity income investors do to protect themselves?
A solution may be found in diversifying UK equity exposure outside of the kind of stocks that typically constitute the core of the equity income sector and to see yield not as a target, but as a useful by-product. It is more important to find companies with positive operational momentum, which are growing their revenue and earnings faster than consensus expectations. These companies often go on to positively surprise in their ability to distribute free cashflow to investors and thereby provide a useful income.
Many such businesses have the potential to generate attractive dividends and their growth characteristics mean they are likely to be able to go on raising their dividends at a higher rate than the market average in future. They also have the potential to increase pay-out ratios over time and may be in a position to make special distributions.
ITV did this in late February, while easyJet announced in November last year that it would pay a special £175m dividend in 2014, while maintaining its 33 per cent pay-out ratio.
This operational momentum often translates into cash generation and associated distributions to investors. Persimmon is another case in point. It announced full-year figures on February 25 in which it accompanied its very strong profits with the promise of accelerating the distribution of its large cash reserves to shareholder.
