The income risk investors need to be aware of

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For income-seeking investors, the UK stock market has a rich dividend heritage. However, an important thing to bear in mind is the highly concentrated nature of UK dividends. In 2024, figures from Computershare show that the top 15 dividend stocks accounted for 59% of all UK dividend payments.

To discuss the issue of concentration risk for income-seeking investors backing the UK market, Kyle is joined by Eric Moore, manager of Slater Income fund. Moore explains how he navigates this income risk, and why he adopts a total return approach to investing in dividend-paying companies.

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Kyle Caldwell, funds and investment education editor at interactive investor: 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 are going to 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, fund manager of Slater Income fund. So, Eric, before I put the questions to you, I'll just set the scene. So, if you're an income-seeking investor, the UK stock market is a very good place to look.

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 100 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, that's according to Computershare.

The top five payers accounted for just over half of all UK dividends, and those five companies were AstraZeneca (LSE:AZN), Shell (LSE:SHEL), British American Tobacco (LSE:BATS), BP (LSE:BP.), and Unilever (LSE:ULVR).

Now when it comes to UK equity income funds, it's 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?

Eric Moore, fund manager of Slater Income fund: Great question. Well, thank you, Kyle.

So, it is an issue. If you look at any one quarter, obviously, it's slightly skewed by whose paying now. But you're right; even over a whole year, which takes out some of the lumps, probably about 12 to 15 stocks make up about half the market total income in terms of pounds.

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 we've got some big companies that also are big dividend payers, but it's not actually just an income issue.

If you just looked at the market capitalisation of these companies like Shell, BP and British American Tobacco, the companies you mentioned, they also dominate the capital side of the index. So, they're just the biggest companies.

If you looked at the weight of stocks within the index, probably about 15 stocks are typically half the market in terms of capitalisation. So, even if you owned a tracker fund and you think you're massively diverse, and you're not particularly thinking about income or anything like that, you're just thinking that [you've] got a diverse play on the UK stock market. Actually, half your money is going to 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.

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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.

Eric Moore: That's right. So, the Slater Income fund is what we call all-caps. We have some FTSE stocks, we have some mid-cap, some small-cap, and some AIM stocks. We get around this problem of concentration of both the benchmark and and where the income is coming from by investing across the capitalisation ranges, so, big, medium and small.

We have some big ones, as you point out, like we have Shell, which doesn't have a supersonic yield, but yields about 4% and 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 some of the bigger-yielding stocks in the market that we've avoided. So, we don't own British American Tobacco, for instance. We don't own HSBC Holdings (LSE:HSBA), which is one of the biggest-yielding stocks in the market as well.

We think there's plenty of stocks out there with good attractive income characteristics that we can manoeuvre away beyond the top ones.

Kyle Caldwell: So, overall, you hold less than the index in, say, the top 15 dividend-paying companies?

Eric Moore: That that would be correct, yes. So even where we have Shell, we probably don't have as much as it represents in the index, and [there's]nothing really wrong with the FTSE 100, but what we're trying to find are companies with a good yield that are also growing, and it tends to be some of those very big companies, it's the growth bit that they will find quite hard to deliver for us.

Kyle Caldwell: So, by focusing on companies of all different sizes, this is the way that you try and navigate concentration risk?

Eric Moore: That's right. In the portfolio itself, we've got 45 stocks, which we think is a nice number. It's concentrated enough that everything there is pulling its weight, and we don't have a sort of a ragbag and a bit of a tail, but also it's enough to provide decent diversification.

Kyle Caldwell: What's the current split between large, mid-caps, and small-caps?

Eric Moore: Very roughly, we have about just under 40% in small-cap and AIM together, and then we'll have a bit less than 20% in mid-caps, and then whatever that leaves us with, sort of about 40%-ish in FTSE 100 stocks. We don't use those as targets, but that's kind of how the portfolio has been for the last three years or so. It's been pretty consistent.

Kyle Caldwell: Why do you think it is that so many fund managers gravitate towards the biggest payers? Is it because they mainly focus on larger companies and also [due to] a fear of underperforming the index drastically by being so different from it?

Eric Moore: Yeah. There's a bit of that, I think. So, we are very benchmark-agnostic, if you like. We're aware there's an index out there. We know we'll be compared to it and understand that.

But when we come to how we think about the stocks we want to have in the fund, we don't really think about what their shape is in the index or what other people are doing.

We judge each stock more on its own individual merits, perhaps more with an absolute return mindset that we want to buy shares that are cheap on an absolute basis.

And we're not afraid to not own big stocks. So, for example, AstraZeneca is the biggest stock in the index by - I'm not even sure [by] how much it is, but it's a big old unit. And we're happy not to own a share in that.

There's lots of stocks beyond the obvious hunting grounds. We also benefit from the fact the fund is relatively small, so that makes it easier. Some of the big funds that have been very successful, they get to the size where they become quite big, so it gets harder to explore some of these smaller-cap situations.

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?

Eric Moore: It certainly helps. Yeah. So we say, as an income fund, people would expect us to own stocks that are generating a dividend. And if we own any individual shares that don't pay dividend, it just puts a lot of strain on all the other stocks in the portfolio to have to work harder for it. So, I take the view that unless you're yielding, you're probably not for our income fund.

We don't put hard and fast rules around it, but broadly speaking, if you yield less than 2.5%, you're not going to get me very excited.

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.

It's no good just buying companies that have a high yield but aren't going to grow their dividend because you're just a bond. So, if you've got companies that are yielding 6%, but not growing the dividend, then your total return from that is probably going to be 6%. So, it's not really good enough.

You're better off in a company, even if it yields a bit less, say, 4%, but you're growing the dividend at 5%, 6% or 7% in a sustainable way, that should drive a double-digit total return.

So, a really simple rule of thumb and something I look at is to say, is the yield plus the forecast dividend growth more than 10%? Then that's a good start.

As I said, yielding 4%, growing at 7%, gets you 11%. That's a really simple good first base because it should mean, other things being equal, you should get a double-digit total return from that. And if you compound that for a few years because the dividend growth is sustainable, then we'll all be happy.

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Kyle Caldwell: Could you name some stock examples, obviously you've got a number of them in the portfolio, so perhaps you could mention a larger company that you have exposure to and then also a smaller company as well?

Eric Moore: Sure. So, there's a range. I say everything should be yielding and growing, but there is a bit of a range within that. We have some stocks that are yielding quite a lot, like Legal & General Group (LSE:LGEN), now that probably yields the thick end of 8% at the moment, but the dividend growth is probably only 2% or 3% at the moment.

So, that gets you to my 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 shares in Workspace Group (LSE:WKP) lately, where we think the dividend should be growing quite strongly.

In some of the building material stocks, we like Genuit Group (LSE:GEN). We think the dividend growth this year is not going to be great, but we expect it to accelerate.

So, everything is contributing both to the yield and to the growth.

Kyle Caldwell: How do you assess that the dividend is potentially going to be sustainable over the medium to long term? There's, of course, always a danger that a company management team overprioritises a dividend, and they try and keep shareholders sweet rather than putting that money back into the business.

Eric Moore: Yeah. Absolutely right. We talk about good and growing dividends. So, you can say, well, what does 'good' mean? And as I said, probably more than 2.5%, but also the quality of it.

So, not just the quantity, but is it covered by earnings? Is it covered by cash flow? And also importantly, 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 that we're expecting this year is robust.

But it's really important that companies are reinvesting as well and have avenues for growth. And 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 grow. We're not talking about necessarily 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.

So, what will it be about a company that will mean they can do that? Well, it'll be some sort of wind in their sails. 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 coalesce around people with a plan. It's usually about the management team who understand the business and have got a plan to execute it for the next few years.

We meet a lot of companies. We're very bottom up, as I 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 macro stuff; 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 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 really excites us.

Kyle Caldwell: Slater Income fund, at the moment, its yield is just above 5%. You mentioned Legal & General earlier as an example of a high-yielding stock that you own. I assume you'd have to have exposure to a couple of other chunky dividend payers in order for the fund to yield that much. Could you explain which ones you hold?

Eric Moore: Sure. As I said, there's a range. We want everything to be yielding and growing, but there's a bit of a range within that. Some of the higher-yielding stocks we've got include Legal & General, which I mentioned, and M&G Ordinary Shares (LSE:MNG), another life insurer/asset management firm. 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 gratifying. That was offering a yield of 10%, which is kind of crazy.

I think it's particularly crazy because 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&G and also Legal & General, the dividends this year are being generated by business they wrote years ago from the back book. So, actually, the dividends are kind of more dependable than, say, 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 the back book's 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, so growing the dividend is harder.

Other high yielders or also in financials, we own quite a lot of the smaller fund management companies. We own Liontrust Asset Management (LSE:LIO), which has been difficult for us, but has a very big yield, which will probably be cut, by the way. That dividend does look very vulnerable.

We own Polar Capital Holdings (LSE:POLR), which yields about 10%, and we own Premier Miton Group (LSE:PMI) where the dividend yield is about 8%.

So these businesses, the fund management companies are very operationally geared. They're very sensitive to the levels of funds they run, the amount of money they run. In the short term, the costs are relatively fixed because it's mostly people in buildings, regulation and a bit of tech. 

But their revenues will wobble around with the amount of money they run, and all these firms 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, 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, so the operational gearing can work both ways. So, if the sun comes out a little bit and the UK fund management industry starts to see some inflows, heaven forbid, then the picture for those dividends could look more robust quite quickly.

Also importantly, and I mentioned the significance of debt before as a thing to worry about when you think about dividends, all these companies have net cash. So, even if the dividends aren't entirely covered by earnings, 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.

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Kyle Caldwell:And in terms of the 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 that make you more wary about the ability of a company to pay a future dividend?

Eric Moore: Yeah. Absolutely. If your dividend cover is less than one, that means you are robbing the balance sheet in some way. So, if you've got a load of cash, then perhaps it's OK. But if you are taking on more debt to pay your dividends, then that looks tricky.

And that's the situation that Liontrust 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.

But the forecasts have continued to deteriorate, time has passed, the business has still been in outflows and performance of their funds is not great. So, now they look at it and they probably say, even on a three-year view, we're 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, right?

So, Liontrust is in some position to keep going. I think the shares now yield over 20%, so it's not going to 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, a good example would be Imperial Brands (LSE:IMB), which used to be Imperial Tobacco. 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, a small engineering company where the profits are very uncertain or certainly more volatile, I should say. So, it does depend a bit. There's not one magic number.

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. What needs to happen for that to change? We've seen a lot of money go into global equity income funds. Could you make the case for investors returning to the UK as opposed to going overseas?

Eric Moore: You're right. Outflows have been very persistent, and I'm surprised there's anyone left to sell it, just seeing the outflows we've had over the last few years on the Calastone data. It's been awful, really, from my point of view as a UK investor. I should say at Slater Investments that we just do UK funds. So, what can be done about it?

I think there's various things. There's some government initiatives around. There's some high hopes around the Mansion House address coming up in July. But these are not within our gift as fund managers. There's lobbying going on. We've participated 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. For why maybe people should think about the UK, one interesting way of looking at it is if you think about what the UK's gone through in the last 10 years. It's been pretty brutal. So, the Brexit referendum, which kind of caught everyone out, to be honest. Then we had, will it be a hard or soft Brexit? And that whole process got terribly drawn out.

Then we had Covid, and we've had a sort of revolving door at Number 10. So, there's been a lot of uncertainty through that process, a lot of reasons for companies and consumers to just sit on their hands. You've seen that in lower housing transactions on the consumer side, less big-ticket spend, and also lower investment from companies.

So, that ability to plan has just gone out the window, really, over the last 10 years. The UK economy has been through 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. The economy has been more resilient, and I see at the companies I meet, they've all been through the mill as well, and they just want a little bit of peace and quiet.

It could just be that the UK is in a period of relative stability now, and by contrast, the inability to plan and the ability for anyone to make any sensible decisions, the sort of hotspot for that, if you like, is now North America with what's happening in their political situation and indeed their economic one.

So, I think perhaps the UK is beginning to look a bit more sensible on a relative basis.

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. I'll see you next week.

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