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What does Newton divi cut mean for equity income funds?

What does Newton divi cut mean for equity income funds?

Newton’s flagship Higher Income fund recently announced it is cutting its yield target by between 20% and 25% in a move that calls into question the sustainability of delivering a consistently rising yield.

Investors flocked to the fund owing to its impressive yields that grew annually for the  past 15 consecutive years. Distributions in the last five years have been 4.6%, 5.7%, 7.2%, 7.6% and 7.9%, and its popularity has seen the fund grow to £2.5 billion.

Manager Tineke Frikkee (pictured) took pride in the fund’s impressive track record and level of discipline, recently saying it was still on track to deliver 3% annual dividend growth in the year to the end of June 2011. 

‘This contrasts markedly with the 10% decline in UK market dividends paid during 2008 and our previous forecast of a 10% decline in UK market dividends in 2009,’ she said.

However, the high yields have inevitably meant that the fund has missed out on opportunities for capital growth and the cut in the yield target aims to address this.

In the three years to the end of July, the fund returned 21.4% on a total return basis, against a 22.8% gain in the FTSE All Share. For the year ending July the fund has returned 10.9% versus a 14.9% rise in the benchmark.

Hargreaves Lansdown openly showed concern about the Newton Higher Income fund’s dividend policy in November 2010, when it removed it from its Wealth 150 buy list. The firm believed Frikkee was excessive in her use of covered call options as a means to hit the targets at the expense of growth.

Mark Dampier, head of research at Hargreaves Lansdown, said of the fund cutting its target: ‘It doesn’t come as any surprise. It’s just the right thing to do.’

Divi yields too high

But is the move also a sign that high dividend yields are increasingly hard to come by? Dampier argues that yields are already high on many funds, and on Newton’s Higher Income fund it was just too high.

He explained: ‘They stuck out like a sore thumb with this incredibly high yield. Yields are quite high anyway, but 7.5% is ridiculously high.

‘It shows you that when funds get up to super high yields you have to be wary. I think they got themselves into it and were not able to make it sustainable. It’s much better to preserve the capital. Funds that are yielding about 4% to 5% are probably better. If you go for the very high income, capital returns suffer.’

However, Frikkee told Wealth Manager she still believes attractive dividend yields and rising dividend payments will be ‘relatively easy’ to
find during the next 12 months. She expects overall dividend income from the UK market to grow by 10% this year and by another 10% during 2012.

Even so, she said forecasts for 2013 may well prove tougher. ‘We believe dividend income and dividend growth will be more significant contributors to the lower expected total return level than in the past 10 years, but that the dividend growth level from equities is likely to be below long-run historic levels as earnings and cash flow growth slow,’ she explained.

The Newton High Income fund is already firmly within the defensive camp but looking ahead, this is where Frikkee expects to continue finding decent yields.

She said: ‘As earnings will be downgraded during the last four months of the year, we believe investors may be best placed to look among stocks referred to as “stable growers”, whose earnings and dividend forecast risks are relatively low. These areas include pharmaceuticals, tobacco, telecommunications, utilities, food producers and food retailers.’

The sentiment is echoed by PSigma fund manager Bill Mott, who argues that while global growth is set to slow, there are still sectors where dividend yields will see comfortable rises.

He said: ‘Normally, when the yields on equities are as high relative to bonds as they are at the moment, most of the yields are in sensitive areas of the market. But this time you have got very defensive areas of the market and there are loads
of opportunities.’

Singling out the most attractive firms on a dividend growth basis, Mott highlights Vodafone, Tesco and Unilever.

‘I think that the duration of their dividend growth is very high – you can expect those companies to be able to grow their dividends for
a sustainable period. I don’t think many people believe that Tesco won’t grow its dividends for the next few years,’ he argued.

However, the search for solid and rising dividends may mean investors have to change their mindsets.

‘I think the developed world, but also the developing world, is going through a long period of adjustment where we will have to get used to slower growth. If I had to capture it in a catchphrase it would be “predictability is undervalued”.’

He added: ‘If the economic environment continues to deteriorate for the next few years, we could see a change in investor attitudes to the less exciting areas of the market, for example food
and tobacco.

‘There are a number of opportunities out there to lock in companies that have good market presence, cash flow and dividend-paying potential.’

Charlie Luke, senior investment manager at Murray Income Trust, pointed out that payout ratios are historically quite low and he believes investors can still look outside the traditional realms of the defensive sectors.

He cited media company Pearson as one stock that will be useful in delivering income growth in future, while supermarket group Morrisons has committed to grow its dividend by 10% annually over the next few years.

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