Where Can Income Investors Find Dividends Now?

The outlook for dividend stocks is looking gloomy - but there are still opportunities out there for the income investor. Evenlode's Hugh Yarrow reveals what to avoid and where to look

Emma Wall 11 February, 2016 | 12:10PM
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Emma Wall: Hello and welcome to Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Hugh Yarrow, Co-Manager of Evenlode Income Fund.

Hi, Hugh.

Hugh Yarrow: Hi, Emma.

Wall: So, you wrote a piece for us in December and the tone was surprisingly pessimistic in the outlook for dividends. It was going to be that you can still find dividend-paying stocks, but unfortunately it's going to be lower dividend growth and lower dividends overall for 2016. So far that’s proved true, hasn't it?

Yarrow: Yes, there are obviously some very specific issues in particularly the commodity and energy sectors which is dragging on the overall dividend outlook for the U.K. But I think more generally economic growth is slow and has been slow since 2008 downturn and corporations, whoever they are, even resilient businesses, are finding it more difficult to generate top-line growth and that does mean a more modest outlook for dividends.

I think another sort of specific point over the last couple of years has been that Sterling has been relatively strong, particularly against non-dollar global currencies and that clearly provides a headwind for multinational companies listed in the U.K. that earn their money overseas and then it's reported back into Sterling.

Wall: You mentioned commodity stocks there. Of course, dividend cuts lag loss of profit and so we probably expect to see some more commodity stocks losing their dividend over the course of this year. However, those that still have, they are looking pretty attractive yields. We're seeing sort of Anglo American at 15%, BHP Billiton at 12%, Glencore 11%. I know you have said in the past be wary of high-yielding stocks, but surely there has got to come a point where you think actually the valuations on these are so compelling we can't ignore them?

Yarrow: Well, our process is to focus on asset-light business that have strong intangible assets and generate a high return on invested capital. So, we don't actually invest in commodity and oil-producing stocks at all, so we leave that to other people. I mean, the stocks you mentioned there are actually Anglos and Glencore have both announced cancelations of the dividend already. So, those headline yields are effectively going to disappear within the next few months. But I would make a more general point in the current sort of sentiment which is becoming increasing negative, there are some more interesting opportunities emerging.

I think for us, a couple of things to focus on in terms of dividend sustainability and the potential for growth is firstly, high unsustainable free cash flow. Cash flow is what's left in the till at the end of the year, what pays a dividends. We like repeat purchase business models, whether that's from subscriptions and software or media businesses or whether that's selling soap or shampoo or toothpaste. And then also looking at balance sheets and that's absolutely crucial and we're particularly wary of more economically-sensitive businesses that have debt on their balance sheets because often in a downturn that is where dividend cuts, as you are currently seeing in the commodity sector, come from.

Wall: That leads us to where you are investing at the moment. You have a big overweight in consumer stocks. I mean, is this something that you see continuing to play? Are these sort of buy and hold forever-type investments?

Yarrow: They are not buy and hold forever. We do have a valuation-based approach, but these are fantastically high-quality companies with very strong and sustainable and stable free cash flow and I think in the current market investors are being reminded of those qualities. The consumer branded good exposure that we have we still think offers good value particularly on a quality and risk-adjusted basis over the long term. But I would also point out that there are some other interesting opportunities emerging in other areas and if that trend continues in the market, then we may well use those positions as a source of cash and driven them back to invest in other opportunities that are emerging.

Wall: What are those opportunities that are emerging?

Yarrow: Well, I'd particularly point out the sort of smaller company sector in the U.K. which has had a fantastically strong place for performance over the last five or six years. When we launched the fund six years ago, we had a large exposure to smaller companies, but due to valuations we increasingly reduced that. But in the last few months, you're starting to see selectively some opportunities reemerge, very high-quality businesses which have very strong balance sheets, very strong free cash flow and good potential for dividend growth. So, that's an area that we think is becoming increasing interesting now.

Wall: Hugh, thank you very much.

Yarrow: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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