The manager of the £679m Standard Life Investments UK Equity Income Unconstrained fund says there is substantial risk to the dividends of Royal Dutch Shell, BP and GlaxoSmithKline, which are widely held as major positions by funds in the IMA UK Equity Income sector.In the sector, 43 funds out of 89 hold both GlaxoSmithKline and BP in their top 10 holdings with F&C UK Equity Income, HSBC Income, Jupiter Income Trust and UBS UK Equity Income most exposed with more than 10 per cent exposure.
Just nine funds hold Royal Dutch Shell and GlaxoSmithKline with SWIP Higher Income and Newton Higher Income the most exposed with a collective 14 and 13.4 per cent of the funds in the two stocks.
FE data shows that only 8 – or 9 per cent – of UK Equity Income funds don’t hold at least one of the three companies in their top-10. A number of these such as HL Multi Manager Income & Growth are fund of funds, and have high underlying exposure to the companies. Others such as Unicorn UK Income and Miton UK Multi Cap Income are focused almost exclusively on small caps.
Indeed, Moore’s Standard Life UK Equity Income Unconstrained fund is the only genuine multi-cap portfolio in the sector that doesn’t have a major position in BP, Glaxo or Shell.
Moore’s words echo a recent study by FE Trustnet, which highlighted that several well-known funds within the popular sector rely on a single company to pay out approximately 10 per cent of their yield.
The manager, whose fund sits in the IMA UK Equity Income sector but doesn’t contain any of the three stocks, says investors should be alerted to the potential for cuts to their dividends due to falls in the price of oil in the cases of BP and Shell and weak sales data from GlaxoSmithKline.
“There are risks among a large number mega caps that are widely held by a number of income funds. It needs to be at the front of investors’ minds. These well-held mega caps are facing top-line pressure which requires a significant cost-cutting response to maintain dividends at current levels,” he said.
“For example Royal Dutch Shell is the heaviest weighting the IMA UK Equity Income sector, almost joint top with GlaxoSmithKline.”
“These risks are either external headwinds such as the collapse in oil prices in case of BP and Shell or internal issues such GlaxoSmithKline is going through at the moment with sales down 10 per cent.”
According to FE Analytics, the three stocks feature prominently in the sector within funds’ top 10 holdings.
Royal Dutch Shell is held by 65.5 per cent of funds as a top 10 position, BP by 55 per cent and GlaxoSmithKline by 73 per cent. The stocks have been important dividend stalwarts for funds in the sector but gave all gained at least 20 per cent less than the FTSE All Share over the past three years.
Performance of stocks and index over 3yrs
Source: FE Analytics
With the exception of BP they have also been hit hard over the past six weeks of market weakness.
Moore says the vulnerabilities in all cases stem from the fact that there is pressure on revenues and that is leading to pressure on earnings.
Performance of stocks and index since 4 Sep
Source: FE Analytics
Moore says a key reason for the risk to dividends to the oil majors is a material decline in the price of oil in recent months.
“The decline in the oil price is particularly unwelcome because it comes at a time when [Royal Dutch Shell and BP] have been putting a very high amount of capex into very high marginal cost projects such as gas-to-liquid, shale and oil-sands.”
“These require the oil price to stay at elevated levels for them to be economical. If you run the scenario of oil at $80 per barrel you will see earnings downgrades at Shell of 27 per cent in 2015 and 26 per cent for 2016.”
Performance of index in 2014
Source: FE Analytics
Moore says the market would see earnings downgrades if this were to happen, also putting downward pressure on the firms’ share prices as investors “suffering from group think” and move to trim their holdings in the groups.
“There is a case to be made to diversify away into growth stocks in the small-cap and mid-cap spaces and to not be lured into funds simply as a function of their size. There is a tendency for the larger income funds to invest in the largest stocks in the index. These may not be the optimal stocks for investors.”
The manager also highlights problems facing pharmaceutical giant GlaxoSmithKline.
“GlaxoSmithKline is the second most widely held in the sector and investors should be wary of this. Pharmaceutical stocks are a risk that could spring up. It is a slow incident waiting to happen,” he said.
“[Glaxo] has just reported results. This company is one whose earnings are under significant pressure not just on forex but on their respiratory drugs.”
GlaxoSmithKline said in a statement yesterday that it was planning to hold its dividend in 2015 at 2014 levels.
But Moore said: “That is quite ambitious for a company to do at that level in the context of severe underlying fundamental earnings pressure. The way they are going to do this is by cutting costs significantly.”
An overreliance on one stock for income led to a swell of funds in the IMA UK Equity Income sector in 2010 and 2011 cutting their dividends, following the BP Macondo disaster when the oil firm did not make a payout for three successful quarters.
