While many income-focused equity investors say they have a focus on companies that can grow and sustain their dividends, Columbia Threadneedle’s head of UK equities Richard Colwell said it may not always be the right approach. 
According to the manager of the £4.2bn Threadneedle UK Equity Income fund, investors may be too complacent about dividends from quality businesses and should look to add companies that are showing signs of a turnaround.
“It is interesting to observe that most people would say it is all about the quality and the sustainability of dividends and that it is about dividend growth rather than being attracted to just high yielders. Obviously, there is some sense in that comment,” he said.
“But the problem is that those quality dividend growers have, quite rightly, got re-rated this cycle so to keep buying more of those stocks where the yields has now come down to 3 per cent or lower isn’t necessarily best for capital growth opportunities as well as giving a yield premium at the fund level.”
Performance of stocks vs FTSE All Share over 10yrs
Source: FE Analytics
As the above chart shows, quality, dependable dividend-paying names such as Reckitt Benckiser and Unilever have largely outperformed the FTSE All Share over the past decade.
“People may be too complacent about the sustainability of cashflows that support those yields. Maybe they are based on peak earnings and margins?” he added.
The other area of the market he has avoided, although it has been among the top-performing over the last two years, is the mining sector.
“Hands up: in the income strategies that I am involved in we missed the miner recovery. Well done to those guys who held their nerve and bought more of them at the back-end of 2015 when everyone was very fearful of China,” Colwell (pictured) said.
“I haven’t got stock envy because I know exactly why I didn’t get involved in those stocks. The worst thing you can do is blink and buy other people’s ideas or follow the quant guys.
“If all things are being equal they do offer decent dividend yields but the reality is those dividends might be more dangerous than some of the high-yielding ugly duckling stocks that the market really hates.”
As such, his main strategy for the Threadneedle UK Equity Income fund has been to lean into companies that are more unloved by the markets but that offer attractive dividend yields.
Names Colwell has highlighted as interesting value opportunities include GlaxoSmithKline, BT and Marks & Spencer.
He noted: “They are on big dividends because the market doesn’t think they are sustainable and it could be that a few of those dividends do get readjusted.
“But how much of that is already in the price and would it be alongside other positive catalysts?”
Colwell added: “It is about taking on the market selectively in some of the ugly duckling, high yielding, currently overdistributing stocks and the work you are doing is trying to work out which ones are going to be the next Shell.”
Indeed, the oil giant was particularly unloved three years ago when the prices went into apparent freefall, as the below chart shows.
Performance of stock and Brent crude spot over 5yrs
Source: FE Analytics
As such, the dividend yield on the stock rocketed to more than 10 per cent. Yet, despite concerns that the company would have to scrap its dividend, it has continued to pay out causing the market to re-rate it.
“You have got to take on the market and own some of those high-yielding stocks and that is an important part of the discipline of an income fund manager with a more value orientation,” Colwell said.
At the other end of the spectrum however, he said that investors in equity income can also be too quick to ditch a stock if it comes off the dividend roster.
“It would be very wrong I feel to cleanse the portfolio of any stock where the dividend has been zeroed because quite often that is the cathartic moment where there is meaningful change within a business,” the manager said.
“Within a portfolio in our case of 50 stocks you can afford to incubate a few of those positions because there could be a meaningful capital growth before they are in a position to scale back up on the dividend roster.”
An example of this is supermarket chain Morrisons, which is now paying a special dividend as well as its regular dividend, having cancelled the payout a couple of years prior.
Likewise, Colwell highlighted RSA Insurance Group as another example of a stock that fell off the dividend roster but is now performing well.
The insurer has overcome a number of challenges, including accounting irregularities in its Irish arm that resulted in the exit of former chief executive Simon Lee.
Performance of stocks over 5yrs
Source: FE Analytics
“When RSA had trouble and strife culminating in a rights issue post – amongst other things – the fraud in Ireland, that was a great time to buy more of the stock and build up the position,” he said.
“Yes, you had a few years where there was no dividend from that stock but [the share price] is now well north of the Zurich bid approach a few years ago, you have a nice growing dividend and the potential for specials at some point.
“So those are coming through the hopper and are giving you a kicker. If you waited for them to declare their special [dividend] you would have missed out on a lot of capital growth.”
These are example of companies that have “missed the party” for much of the last decade that has been brought about through quantitative easing (QE).
“They have navigated their own little journey of misery that they are coming out of the other side from. It is about trying to think about a few snooker shots ahead. It just takes time. Recoveries are not V-shaped,” Colwell noted.
Since Colwell started overseeing Threadneedle UK Equity Income in September 2010, the fund has delivered a total return of 141.12 per cent outperforming the 110.15 per cent gain for the average IA UK Equity Income sector peer.
It has a yield of 4.00 per cent and an ongoing charges figure (OCF) of 0.82 per cent.