Interactive Investor

Stock secrets of high-yielding UK income funds

Looking under the bonnet of equity income funds reveals some interesting high-yield stock ideas, writes Sam Benstead.

9th April 2024 09:43

by Sam Benstead from interactive investor

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Dividends paid by companies are a great way to take money out of a portfolio without selling shares, with the UK market offering one of the most attractive yields in the world. 

One way of looking for inspiration is to follow what the highest-yielding UK Equity Income funds are investing in. Here, professional fund managers and their team of analysts select what they believe are the best opportunities as part of a portfolio for dividend hunters.  

We looked at the highest-yielding funds in this sector, using data from FE Analytics. As of the end of March, they were: abrdn UK Income Unconstrained Equity (6.75% yield); Axa Framlington Monthly Income (6.14%); Slater Income (5.82%); Chelverton UK Equity Income (5.67%); and JOHCM UK Equity Income (5.6%). 

Looking under the bonnet, we found that financials, such as banks and insurance companies, were a big overweight, as were basic materials, which includes mining and oil companies. 

Some key overlapping shares “approved” by professional investors were Barclays (4.2% yield); BP (4.4%); Shell (3.7%); Legal & General (8.1%);  GSK (3.6%); SSE (6%) and Aviva (6.8%).  

James Lowen and Clive Beagles, managers of JOHCM UK Equity Income, highlight the appeal of the finance sector.  

On Barclays, they say that it is on a price-to-earnings (PE) ratio of 5 times, coupled with a high dividend yield and its aim to buy back nearly 30% of its own shares over the next three years, makes it an attractive investment.  

In insurance, they say Aviva and Phoenix have delivered strong results this year. “Notably, Phoenix continues to trade on a 10% yield despite upgrading cash-flow guidance and implementing a policy of annual dividend growth," Lowen and Beagles said.  

Thomas Moore, manager of abrdn UK Income Unconstrained and abrdn Equity Income Trust, told investment analyst Kepler that the portfolio invests in “mispriced yield stocks”, one of which is miner Rio Tinto.  

He said: “It has mine lives of decades to come and very low-cost mines which turns out cash every year.”  

He also looks for “income growers” with a runway of income growth over the next three and five years. 

“One example is National Grid, which has income linked to UK inflation. There is no better way of making sure that we achieve growth in income than making sure we own companies with that kind of protection,” he said.  

Moore adds that there are dangers that a yield means a value trap, and that the income is not sustainable. However, he says that there comes a point where companies are so mispriced that it would not even take long for a firm to pay back its entire market cap with dividends and share buybacks. 

He gives some example of deeply out of favour sectors and shares including tobacco, where he owns Imperial Brands.  

“The new management team are obsessed with cash returns. They are handing back around 10% to 15% of the market cap each year, partly by dividends and partly via buybacks. If this company is consistent in doing that, you could get your entire investment back in five years. Reducing the number of shares in issue increases the share price,” Moore said.  

Imperial Brands yields 7.3% currently and is in the top 10 shares of Moore’s investment trust, abrdn Equity Income.

Where the biggest dividend comes from  

The latest dividend monitor from Computershare found that UK dividends rose 5.4% on an underlying basis to £88.5 billion in 2023, although lower one-off special dividends pulled the headline total down 3.7% to £90.5 billion.

It found that HSBC and the wider banking sector were the main drivers of growth, with banks becoming the UK’s largest-paying sector for the first time since 2007.

The research said: “The return to prominence by the banks is really remarkable. Thirteen years of rock-bottom interest rates made it very hard for the sector to make profits, but the need to quell inflation with higher interest rates means the last two years have delivered a dramatic turnaround. Bank investors are reaping the dividends of this reversal and we expect them to see even larger payouts in 2024.” 

Oil and utility sectors also made an important contribution to growth, with high energy prices driving a 15.8% increase in dividends from the oil sector. Inflation-linked dividend policies meant record dividends from utilities, while leisure companies, which are recovering after the pandemic, also delivered a significant dividend increase. 

The appeal of share buybacks 

Jupiter Asset Management UK equity income investors Adrian Gosden and Chris Morrison say that the UK market has rarely been cheaper, with low share prices contributing to higher dividend yields. 

They say BP is the cheapest it has been versus its own history, as is Barclays, and that the FTSE 250 taken as a whole has never been cheaper.  

This has not been lost on private equity, or UK companies, which are buying back their own shares. 

The fund managers said: “We own Wincanton – the premium paid for that by private equity was 100%. We own Direct Line and a buyer is paying a 40% premium for it. Elementis rejected a bid at a 60% premium. This shows how undervalued the UK market is.” 

Companies buying back their own shares also increase the appeal of UK income stocks. 

“Companies think that one of the best uses of their cash is to buy back their own shares, showing how cheap shares are,” Morrison said.  

Buybacks in the FTSE 100, Morrison says, were running at around £10-£20 billion a year but then jumped to £60 billion in 2022, were around £50 billion last year, and are forecast to be higher this year. At £50 billion in buybacks, that is 2.5% of the FTSE 100 market cap.  

“BP is returning $12 billion (£9.5 billion) over the next two years, which is about 15% of its market cap, and Barclays is doing £10 billion over the next three years over dividends and buybacks – thats 40% of its market cap, Morrison said. 

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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