Bill Jamieson: Catch-22 situation for income investors

No matter what opinion polls may be telling us about likely election outcomes, investors have a keen sense of heightened risk.

Don't pile your portfolio into the same 'favoured few companies', urges Bill Jamieson. Picture: Daniel Leal-Olivas/AFP/Getty Images
Don't pile your portfolio into the same 'favoured few companies', urges Bill Jamieson. Picture: Daniel Leal-Olivas/AFP/Getty Images

When it comes to making investment decisions, a natural caution kicks in. There is a preference for a more defensive stance and a bias towards big domestic companies with attractive-looking dividend payouts.

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This bias towards the FTSE 100 behemoths is reinforced this time around with deeply uncertain election outcomes across Europe with the potential for huge financial tremors should the first round of the French presidential election boost the prospects of a Marine Le Pen victory.

Across the Atlantic, there are doubts as to whether US president Donald Trump will be able to effect the tax cuts and infrastructure spending boost that formed a core part of his election campaign. Add to this the subsequent wayward nature of his pronouncements and the appeal of sticking with UK income-orientated investment trusts and funds becomes all the more potent. But is this a strategy that de-risks our investment nest eggs – or one that works to heighten vulnerability?

A timely warning has come from Mark Whitehead, manager of Edinburgh-based Securities Trust of Scotland, a pillar of the Martin Currie investment house. The bull market over the past year, he argues, has hidden a number of threats — both to the UK economy and to domestically focused companies. Prominent among them is the slowdown in consumer spending. Retail sales fell by 1.4 per cent during the first three months of the year and a slowdown in domestic demand is the main reason for an expected fall in overall UK growth in the first quarter to 0.4 per cent compared with 0.7 per cent in the prior period.

Meanwhile, the eight-week election campaign with its all-too-familiar promises of higher spending and political give-aways is set to draw attention away from the UK’s poor fiscal position. With many FTSE 100 stocks already looking fully valued, there are plenty of potential pitfalls for UK shareholders.

But there is another hidden risk for today’s investors. As Whitehead said, there is a lack of diversity within the UK dividend-paying companies leading to concentration risk. The top 20 dividend stocks of the FTSE All Share, he points out, account for 64 per cent of the total payout. Widen this to the MSCI Europe and the figure drops to 39 per cent. For the MSCI World Index, the top 20 dividend stocks pay out just 18 per cent of the total.

Not only is there stock-specific concentration risk in the UK market, he adds, but these stocks are also grouped into just three sectors: financials, consumer goods, and oil and gas. And two of these three have question marks over dividend ­sustainability: the banks (vulnerable to interest-rate risk) and oil and gas, which has seen input pricing fall in line with the oil price over the past three years.

Higher-yielding companies are more likely to cut dividends, with stocks yielding between 9 to 10 per cent on average cutting their payouts by 25 per cent over the past ten years. Even those yielding a more modest 5 to 6 per cent have on average cut their dividend by 5 per cent over the past decade.

A similar warning has been sounded by Ben Lofthouse, manager of the Henderson International Income Trust. In the UK stock market, the top 20 companies pay 70 per cent of all UK dividends; the top ten pay 50 per cent; the top five, 35 per cent. Analysis by Henderson of UK equity income funds and trusts above £200 million found that 26 per cent of the money managed by the entire sector is invested in just ten companies.

Lofthouse said: “It does raise the idea of concentration risk. UK-based investors are likely have the majority of their interests focused here, be it their job, houses, cars, investments, and so forth. Investors also often hold multiple funds to try to protect against a singular manager’s poor performance, but they are likely duplicating across many of the same stocks.”

But the Catch-22 for investors is that a stronger pound could spell a reversal in fortunes for investors in the big overseas earners.

If the pundits are to be believed and the Conservatives achieve a stronger working majority, sterling is expected to strengthen further with the result that investment sentiment could swing from the FTSE 100 giants with large overseas earnings to funds and trusts with deeper exposure to domestics or companies that might benefit from importing.

It pays to take care that when spreading investments over a variety of trusts, you really are achieving risk diversification – and not ­piling up more of your underlying portfolio in the same favoured few companies.