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Mark Barnett: prepare for reality check on dividends

Dividend growth is likely to slow, warns Invesco Perpetual's top-rated income fund manager, but at least banks are making a come back.

 
Mark Barnett: prepare for reality check on dividends

Citywire AAA-rated fund manager Mark Barnett has warned investors not to expect dividend growth to continue at its current levels, as dividend cover hits its lowest level in six years.

UK companies have dramatically increased dividend payments since the financial crisis, with headline payouts rising from £58.7 billion for FTSE 100 and 250 stocks in 2010 to an estimated £87.2 billion this year.

Those payments have increased at a faster rate than earnings, with dividend cover for stocks set to fall to its lowest level since 2009, at 1.2 times earnings. Dividend cover is the ratio of a company's earnings in a year to the amount paid out in dividends.

Barnett, manager of the Invesco Perpetual Income and High Income funds, said that trend was unlikely to persist next year.

'The outlook for dividend growth is going to be much more clearly aligned to earnings growth,' he said. 'The best we can hope for is earnings and dividends to rise in line. It will be a slower rate of growth than we have seen in recent years.'

Barnett, who also manages the Edinburgh (EDIN ), Perpetual Income & Growth (PLI ) and Keystone (KIT ) investment trusts, expects UK company earnings to rise between 3% and 4% over 2016. Dividends should grow by the same amount, although he cautioned they could lag earnings growth if companies instead decide to repair their dwindling cover.

Falling dividend cover was one reason behind Barnett's decision to sell his holdings in pharmaceutical giant GlaxoSmithKline (GSK) across all his funds. He added that the company's faltering growth potential was another.

'Differentiation will increase between [pharmaceutical] companies investing in new sciences and those that aren't,' he said. 'That's one of the reasons I took out the holding in Glaxo.'

He contrasted the approach of AstraZeneca (AZN), which has raised its research and development budget. He argued those companies ramping up development of new drugs would be better placed to withstand pressures on pricing.

'In an environment where pricing power has been challenged, new intellectual property can deliver pricing power,' he said.

Oil fears 'overblown'

Dividends look most vulnerable in the commodities sector, where earnings have been tumbling, but Barnett's colleague at Invesco, Citywire AAA-rated Martin Walker (pictured), argued fears over the oil majors' dividends were 'overblown'.

Walker, manager of the Invesco Perpetual UK Growth fund, holds BG (BG), BP (BP) and Shell (RDSb) and said they had demonstrated 'a real intention to push the oil price deflation onto their supply base'.

The oil price has remained subdued throughout 2015 after last year's crash and is now trading at less than $44 a barrel, but Walker said over the next two to three years, he expected it to rise.

'In the end demand will surprise on the upside,' he said, pointing to low prices that were encouraging some consumers to trade to cars with larger engines. He added that the supply glut was unlikely to persist, with millions of dollars of capital expenditure wiped from the balance sheets of oil explorers, and questioned the ability of the US to further ramp up shale oil production.

'When we look at the extent of shale production in the US, it is already at high levels and I question how much further that can go,' he said.

Should the oil price rise towards $70, the oil majors, which have crunched their cost base to cope with $50 oil, will be hit with a 'wall of cash', he said.

Walker was meanwhile bullish on banking stocks, and even Barnett, who like his predecessor on the funds, Neil Woodford, has long shunned them, said they were 'potential new areas of interest'. 'I'm keeping my eye on the banks,' he said.

Walker described the banks' success in the Bank of England's stress tests this week as a 'watershed moment'.

'Effectively, the Bank of England has said there will be no further capital creep on these businesses,' he said. 'These businesses, which are vey cash generative, will be able to increase their dividends.'

Walker added that the premium paid for 'defensive' stocks – those which show more resilience in the face of market volatility – had reached 'quite a stretched level'. While their premium versus 'cyclical' stocks could stretch further, history suggested only a plunge into global recession would warrant an even greater divergence, he argued.

Walker has been building his cyclical exposure throughout the year, including miners, conceding 'it's clearly been a challenging second half of the year'. Rio Tinto (RIO) is among his top 10 holdings in the fund.

'Compared to the oil sector there's probably less self-help scope,' he said. 'To some degree you probably are more reliant on a recovery in commodities prices.'

He argued that, as with the oil price, commodities prices were likely to lift from their low levels. 'It may take some time to work through, but given where we are in terms of sentiment, even a small change in sentiment would have a significant impact on share prices.'

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