The UK equity income sector has been out of favour with investors for a number of years now, with consistent outflows since the EU referendum in 2016. This marks a stark change in fortunes for a market that peaked at £64bn in size that year and is now just £44bn. The sector also faced significant pandemic-related challenges in 2020 as companies cut or postponed dividends in the face of economic uncertainty.
Dividend payments recovered strongly in 2021 but will likely take a number of years to return to 2019 levels. Some investors seeking regular income have backed growth funds, with the expectation they will be able to take regular profits due to strong capital growth. This clearly only works when the value of companies in these funds is going up, and current conditions remain challenging for this approach. Income stocks, in contrast, enjoy far more predictability when it comes to dividend income.
The Russian invasion of Ukraine has had a significant impact on commodity prices and further exacerbated inflationary pressure, both of which were already building as a result of global supply chain disruption and supportive monetary policy in response to the pandemic.
Cost inflation, particularly in energy, has the potential to significantly impact both consumers and corporates across a range of sectors.
With global inflationary pressures building, we believe holding a portfolio of companies that can continue to grow dividend payments is an increasingly attractive option. As income investors focused predominantly on small and mid-caps we continue to search in a different area of the market to most for dividend income.
Sector weightings differ greatly at the lower end of the market cap scale, and our long-standing exclusion of commodity sectors provides diversification beyond just market capitalisation. Due to the relatively high index weightings of resource sectors in UK markets, income funds have traditionally had significant exposure to this area, which has proved beneficial during the recent period of commodity inflation.
In spite of the absence of a direct commodity tailwind we feel our approach, underpinned by a strong track record of long-term dividend growth, should become increasingly relevant in this higher inflationary environment, and is capable of delivering attractive levels of dividend payments and capital growth. Our investment philosophy is built on the premise that there are a number of good quality, well-financed small and mid-cap companies that have the ability to organically grow both profits and cash returns to shareholders. Over an extended period the combination of strong growth in profits and dividend payments should drive attractive total returns for investors.
Balance sheet strength also plays an important role in the sustainability and growth of dividend payments. There are businesses that have been affected more than others by recent events but we remain confident that balance sheet strength will ensure healthy shareholder payouts.
We continue to favour businesses with low levels of debt. Well-financed companies are also in a better position to weather periods of higher inflation and its associated higher interest rate environment as their interest rate burden is usually low and less variable or completely non-existent.
The merits of the firepower that a strong balance sheet provides for strategic investment is significantly amplified in an environment where competitors may be struggling. Higher-yielding companies are also more value-orientated by nature. For the past decade the high valuations of growth companies have been established by discounting future cashflows using a low discount rate. This low rate is hard to justify in a rising interest rate environment and, as such, some of the more aggressively valued growth companies have come under pressure.
Meanwhile, higher yielding small and mid-caps have proven to be more resilient. We believe a high-quality portfolio of higher-yielding small and mid-caps with the ability to effectively manage inflationary pressures and grow dividend payments is an attractive approach for investors in this current uncertain environment.
Fraser Mackersie Co-manager, Unicorn UK Income Fund
Simon Moon Co-manager, Unicorn UK Income Fund
See also: The best UK equity funds for your ISA