Exploring the resilience of UK dividends

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Hello, I’m Chris Salih, investment Research Analyst at FundCalibre, and today I’m delighted to be joined by Carl Stick and Alan Dobbie, co-managers of the Elite Rated Rathbone Income fund. Thank you both for joining us today.

So Alan, let’s start with the UK stock market. It’s had a challenging number of years, really, it’s underperformed global peers for a long time, struggling to attract new companies. We hear about the discount of UK equities versus other parts of the world, very few people investing in here, outflows, et cetera, et cetera. In a nutshell, does it worry you, I mean, the UK’s the most mature market, the leading market for dividends is that something that could ever change in the near future? Or are you relatively sort of comfortable with the situation?

[00:47] Alan Dobbie: Yeah, well, I mean, as you highlighted there’s no getting away from the fact that the UK has had a difficult few years. You know, if you look in comparison to the US market, US market’s benefited from, I would say it’s a virtuous circle of companies delivering decent earnings or decent earnings growth That’s led to investor inflows, the market re-rating higher. The UK’s kind of had the opposite. We’ve had slightly weaker earnings growth, that’s led to investors withdrawing their money and the market’s just got cheaper and cheaper and cheaper. So, looking backwards is certainly not a pretty picture, but of course what we are all interested in is, is what happens next. And we’re pretty excited about the opportunity within the UK at the moment. And that’s because all that negativity over recent years means that as you, as you alluded to in the question, the UK now trade an absolutely massive discount versus the rest of the world. It always trades on a bit of a discount. You know, typically 15-20% discount, but we’re now looking at a 40% discount.

And that’s, that’s not something that either Carl or I have seen in our investment careers. And we’re excited about that because that cheapness really is the raw material for future outperformance – certainly on a relative basis. It’s not enough on its own – you need a catalyst as well, but you do need that cheapness to be there. So the big question that we always get, of course from clients is, well, what is the catalyst? And it is a difficult one to answer because you know, catalysts are always easier to spot with hindsight. But one thing that we’ve been pretty excited about recently is the increased political will that we’re seeing to fix the issue really, to fix the issues within the UK market to make it a more attractive place for UK companies to IPO, to stop the, the, the postcode to zip code uplift that companies are looking for by moving their listing from London to New York, to encourage the natural buyers of UK equities, so pension funds, insurance companies, retail investors to get back involved in the UK market.

We’ve seen private pension funds just over 20 years ago, used have a 50% allocation to UK equities. That’s currently at 4%. So, we are seeing increased political will just last weekend actually, there was things in the paper, rumours in the paper that the Chancellor could announce a new allowance, a new ISA allowance, to invest specifically in UK companies. We don’t quite know how that would work if it does get announced. You know, there is increased political will to get this issue sorted, so it will take time, but you combine cheapness and potential catalysts out there. It’s a pretty exciting time for the UK market we think.

And let’s go straight into the sort of the dividend side of things. I mean, that’s the bedrock of most people’s investing and the UK is sort of the first port of call for that often. Maybe just give us an outlook of what dividends look like today. Is there a lot on offer and, you know, are companies holding onto their cash as the outlook is uncertain? Maybe give us a bit of insight into that.

[03:44] Alan Dobbie: Yeah I mean, we think the UK’s actually pretty well positioned from a dividend point of view at the moment. UK companies have obviously been through a huge amount over recent years from with Brexit. Then we had Covid Lockdowns with, had the mini budget last year, ongoing fear of recession. So I think companies have been, they’ve already been relatively prudent. Company boards have been relatively prudent when they’ve been setting their dividends policies over recent years. It’s not like we’re coming from a period of kind of real exuberance.

For our own fund, I mean, we focus a lot on dividend growth. We’ve got a really good track record of growing the fund’s dividend. We’ve grown it in 28 of the last 30 years. We are actually just coming up to our own funds year end at the end of September. So we’re going to be putting through a mid single digit increase in dividend this year. And that, so I mean, that’s going to offset the bulk of the inflationary pressure that we’re seeing, and that’s really important. We try to, you know, we’re trying to make sure that the income we pay is at least as much in real terms as as the previous year to preserve the purchasing power of the client’s income stream.

So what are boards going to be thinking about at the moment? The latest UK economic data has been a bit more mixed. We’ve seen low, perhaps we’re seeing inflation peaking, we’re seeing growth forecasts coming down. I think the consensus is that the UK may be flirting with recession over coming quarters, and that could certainly impact board thinking when they’re setting their dividends for the current year. We also have to always remember currency is so important for UK dividends, so many UK listed companies that declare their dividends and dollars. So what happens between dollar /sterling, if we get dollar strength, then UK dividends are going to be in a relatively good place. So I would say overall we are pretty, I would say cautiously optimistic about the dividend outlook for UK companies over the coming year.

And obviously one of the things that the viewers are quite keen on to sort of know how you interact with companies. So Carl, maybe you talk us through, you, you recently met with a couple of your top 10 holdings, the likes of BAE Systems and Legal & General. Maybe, maybe just talk us through some of those meetings and, and what you look for when you’re talking to management and you know, how do you assess a good company/ bad company, whether things are changing for the good, the better. Just a bit of insight on that, please.

[06:05] Carl Stick: Oh, no, absolutely no problem. I think, I mean, the first point philosophically is we do look at businesses and we view them as being they’re stewards of our capital. They’re stewards of your client’s capital. So when we talk to them, we’re trying to understand, you know, what decisions they’re making about how they allocate that capital into the business. You know, is there a strategic cohesiveness around the strategy? You know, do are, do we understand what they’re trying to do? Is there a vision? But also are they managing the business well as well? You know, it’s operational and it’s strategy. It’s allocation of capital. And are they doing that sensibly? And are the decisions that they are making, are they aligned with what we are trying to achieve in our investment process?

And I think when with BAE Systems and Legal & General, two totally different businesses at two totally different stages but they give you a bit of an insight into how we think about investment feeds through into how we look at companies. So BAE Systems – the old British Aerospace – the chief executive there has been in place since 2017, Charles Woodburn, and he is done a terrific job. He’s done a great job in terms of getting the business very operationally efficient. They’re doing the basic things well. They’re very focused on their core business. They’re generating a lot of cash profit, you know, proper cash that’s being used to invest in the business, cash that’s being used to shore up the balance sheet, to finance the pension, to pay us a dividend. So they’ve done some really good things very, very well.

It’s difficult to look at the tragedy in Ukraine and garner investment benefits from that, but the point is that what we’ve seen over the last couple of years is a structural shift now in terms of security and  defense – spending has gone up. So the visibility that a business like BAE Systems has, has been extended. So there’s that opportunity that, that they can see. And as I say, you combine that with a strong business operationally, and it’s an interesting investment opportunity. Now over the summer, BAE System announced a $5.6 billion acquisition of a business called Ball Aerospace. It’s an American business. So they are choosing to invest $5.6 billion of capital in that business. And that changes the risk metrics for us, and we have to look at that within our own framework.

So, you know, is it a sensible acquisition? Well, it’s definitely strategically important. All aerospace is very much focused on space. And it might be defense, it might be civil, it might be commercial applications and vehicles going up into space. It’s an area that is new for BAE Systems. It is strategically important. It’s probably an acquisition that they should be doing, but it is not without risk, because they’re moving into something different. It’s a big acquisition. There were operational challenges involved in doing that, and they’ve had to pay a decent price to get that business. So from our risk framework, the business risk has changed; it’s a big acquisition. The financial risk has changed; because they’re taking a little bit more debt to do that, but they are financially strong, they can do that and the price risk where they’re paying up a full price to buy that business. So we are still holders of BAE Systems. It’s a business that we want to own, but our interaction with the business over the summer has been very much around understanding that acquisition through our own prism of risk, and understanding how it influences the business risk, the financial risk, and the price risk of our investment.

Legal & General, totally different type of business. The shares are relatively cheap. So on that basis, it’s an investment for us, it’s a good investment for us. It’s a very, very high yielder. But the shares have been cheap for a long, long time. So we do have a feeling of angst around that: why are they cheap? They came out with results, first half results over the summer. That’s when we saw them. The results are absolutely fine. They’re not going to set the world alight, but there was nothing there that got us really worried about the business. But the shares still trade a discount. It’s an important business for UK funds. It’s a big part of the index. It’s a big part of the UK economy. What is interesting with that business and the way the shares reacted on the day, still comes back down to capital allocation because they said, look, everything’s fine. But the market was slightly disappointed because they didn’t announce a big share repurchase. They didn’t say, we are going to allocate some of our capital to buy back our shares because they’re so cheap.

They said two things really, or inferred two things. One was the market’s still difficult, the economy’s still difficult, we’d rather keep that firepower. And they also said, there are lots of opportunities within our own business to invest. We can allocate that capital into our own business. So when we look at Legal & General, we’re questioning our investment decision. The shares are cheap, but what’s the catalyst to change that? Not sure. But we also recognize what the company’s saying: we are choosing to allocate capital within our own business and to make sure our balance sheet remains strong; we’re not yet at a position to buy back shares. So it’s a totally different scenario to the BAE Systems, but both businesses are in our top 10. They both provide us with a decent level of growing dividend Legal & General’s dividend was up 5%. But we are minded they represent different challenges to us as investments.

Alan, Carl, thank you very much for speaking to us today.

[12:16] Alan Dobbie: Thank you.

[12:18] Carl Stick: You’re absolutely welcome.

And if you’d like to learn more about the Rathbone Income Fund, please visit FundCalibre.com.