The building blocks for an income strategy: resilience, growth and diversification

• It’s been a strong year for UK dividends, with underlying growth of 16.5%
• Corporate earnings have proved robust in spite of slowing economic activity
• Despite recent outperformance, the UK market remains close to a record discount when compared to other developed markets

As the interest rate environment has changed, investors have rediscovered the charms of an income strategy. The tangible return of a regular income has had an appeal at a time when inflation is high and the economic outlook is uncertain. However, with predictions for lower growth in dividends in the year ahead, finding a balance between resilience, growth and diversification is vital for any income strategy.

It has been a bumper period for UK dividends. UK dividends rose 8% in 2022. Stripping out the effect of special dividends, underlying payouts rose 16.5%. There has been strong growth across multiple sectors, with almost every sector in the UK market showing double digit growth in payouts. The yield still looks attractive across the UK market, projected at around 3.7% for 2023.

Equally, dividends in the UK market look resilient. Many companies rebased their shares during the pandemic, adjusting their payout ratios. While the absolute level of dividends is in line with pre-Covid levels, there has been considerable profit growth in between. This has left payout ratios (the amount a company pays out in dividends relative to its profits) looking relatively low. This leaves those dividends less vulnerable to any earnings weakness and allows for stronger growth.

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In spite of the weaker economic environment, corporate earnings have proved relatively robust. Companies started the year with near-record profit margins. While we have been alert to the possibility of those margins eroding in the face of higher cost inflation and interest rate rises, it hasn’t happened to date. Companies have shown significant pricing power and have managed to maintain profit margins in spite of a tougher climate. This has allowed dividend increases to continue.

It may be that this earnings weakness does not materialise, at least not for higher quality companies. Cost increases are moderating and there is no reason that stronger companies cannot sustain their pricing power and protect their margins in the year ahead.

Nevertheless, there are headwinds. The most recent Link Group Dividend Monitor predicted that growth in UK dividends would slow to 1.7% in 2023. In particular, the mining sector – which has been a strong engine of growth in dividends over the past two years – is likely to see payouts fall. There is no weakness on the part of the underlying companies, but simply a reflection that the past two years have been exceptional in terms of commodity prices.

A tougher environment will create idiosyncratic problems. The interest rate rises in 2022 and 2023 have been unprecedented in terms of their speed and depth. As the turmoil in the US regional banking sector has shown, it is not always clear where stresses will emerge. Equally, growth may be harder to come by, even if dividends prove resilient.

In the Shires Income portfolio, our solution to this is multi-faceted. The preference share portfolio gives us a reliable income stream that forms the foundation of our income portfolio. The income stream it provides is high, but static. It solves one piece of the income puzzle – resilience – but it cannot solve the growth piece. However, the reliability of the income from the preference share portfolio allows us greater flexibility to hunt for growth. In particular, it means we can retain our weighting in abrdn Smaller Companies Income Trust, the largest single holding in the portfolio. We could reinvest this capital into large cap companies with better dividends, but this holding brings the prospect of long-term growth and compelling diversification. It also has a yield of 3.8%.

There is still a place in the portfolio for the mining sector, even though it may reduce its dividend payouts this year. Even at a reasonable through-cycle commodity price, these companies still look cash generative and pay yields materially higher than the broader market. Longer term, the sector is also positioned for structural growth due to increasing demand for mined commodities required for the energy transition and scarcity of supply.

Above all, we want to retain flexibility in the portfolio, with an ability to recycle into areas that have sustainable, long-term dividends. A growing income is likely to become more important in a climate of higher structural inflation and we want to make sure that Shires keeps pace.

In spite of these caveats, income investors can still feel encouraged. Coming into this year, the consensus was that recession was inevitable. Economic activity and corporate growth have been far stronger than expected. While market valuations are still relatively high and warrant caution, there are plenty of companies with strong earnings growth and fundamentals, raising their payouts to investors. We believe the market will put greater value on these companies in the year ahead and, after a period out of favour, income will be an increasingly important component of total return.

Important information:

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘subinvestment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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