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Shell shock: the income stocks to beat a UK earnings downturn

With profit warnings from the likes of Shell casting a shadow over equity income portfolios. We ask fund managers which stocks offer the best protection.

Shell and Pearson’s profit warnings, alongside RSA’s balance sheet black hole and a looming fine, are stark reminders that dividends are not always safe as houses.

As investors wait to see whether Shell’s anticipated 40% year-on-year profit fall will weigh on its cherished dividend, analysts expect BP will also report a hit from higher exploration costs, lower sales, volumes and prices when it announces its full year results in early February.

Education and media group Pearson posted an 8% profit fall and a further warning last week, while FTSE 100 insurer RSA could face a fine of up to £35 million after a loss of £200 million was discovered in its Irish subsidiary.

This could weigh on future dividend payments; a dividend cut would follow in the path of Aviva last year and raise questions about whether weak earnings threaten UK dividend growth.

That was suggested by a 1% fall in dividends last year to £79.8 billion, according to Capita’s latest UK Data Monitor, the first annual fall since 2010 when BP’s payouts were cancelled in the wake of the Macondo oil spill.

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Reluctant to cut

Capita attributes the slide to fewer special dividends in 2013, weak profitability and lower earnings. Nonetheless, the data provider notes this has still not resulted in big headline cuts.

‘Companies are very reluctant to cut the dividend as this gives a very negative signal to the market. They would rather allow dividend cover to fall temporarily in the hope of rebounding profits and more secure future coverage ratios.

‘In addition, investors are demanding income, and have put significant pressure on boards to sustain dividend payouts while yields on bonds and cash remain so low. Finally, UK plc is cash rich,’ Capita concluded.

Liontrust Macro Equity Income manager Stephen Bailey said stock specific opportunities remain, and urged investors to look beyond the headlines. He has been adding to oil majors and large pharmaceuticals, which he anticipates will benefit from a spillover effect from the £82 billion special dividend due to be paid out this year following the Verizon-Vodafone deal.

‘You could argue that most holders of Vodafone do so because of its income bias. Therefore if you hold Vodafone and a pot of cash comes back to you, where else can you invest for an above average level of income? I think large oil and pharma will benefit,’ he explained.

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Positive on pharma

Although GlaxoSmithKline and Astrazeneca paid out less in dividends in 2013 compared to the previous year, Bailey remains positive on both stocks.

‘GlaxoSmithKline has the ability to rerate. There is the potential for that business to be restructured. Currently you have got an industry that is starting to demerge and dispose of consumer-facing businesses,’ Bailey said.

He also views Astrazeneca’s joint ventures with Bristol-Myers as undervalued by the market.

‘Investors are just starting to wake up to the potential in Astrazeneca’s pipeline. Quite a lot of this is shared by Bristol-Myers… surely some of that should rub off on Astrazeneca,’ Bailey added.

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Second chances

Though Shell’s share price fell following a recent profit warning, Bailey says it has since recovered as investors are prepared to give its new management a chance. He bought more shares on weakness, highlighting its history of increasing and maintaining its dividend.

‘You could suggest that new management have “kitchen sinked”, which means throwing all of the bad news at investors while they have the ability to blame previous management,’ he said.

The manager also started buying BP during the fourth quarter of last year.

‘It is a stock that is still vastly underowned among income investors, as it is still recovering from the shocks and developments of the Gulf of Mexico. But new management is delivering on many promises and you are getting a secure yield in excess of the market.’

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Cigarettes and alcohol

Bailey’s enthusiasm does not extend to utilities or tobacco stocks however, which both face political and social headwinds in his view.

On tobacco he notes that Chinese authorities are considering banning smoking in public places.

‘This is another shock to emerging market tobacco growth and in the US, more and more states are banning electronic cigarettes.’ He added that the ability of tobacco companies to grow dividends could come under pressure as a result.

Citywire AAA-rated Martin Cholwill, manager of the RLAM UK Equity Income fund, argues the contrary. In his view, fears of a slowdown in emerging market growth have weighed too heavily on stocks such as British American Tobacco (BAT). He has added to BAT and HSBC recently. ‘We have still got a big mid-cap weighting. Both shares have been weak on emerging market fears. In my mind both offer a rock solid dividend yield.’

Like Bailey he is also avoiding utility companies, which he believes will face political challenges ahead of the election. ‘We have still got another 18 months to go’, he noted.

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