The Income Investor: why UK-focused shares offer dividend appeal

Companies that are reliant on the UK economy have been derided by income investors over recent years. This is entirely understandable, given that inflation has been rampant, interest rates have surged to a 16-year high and the UK economy experienced a recession in the second half of last year. All of these factors have combined to create conditions that are not particularly conducive to reliable shareholder payouts or rising dividends.

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Now, though, UK-focused income shares are set to benefit from a far more sanguine economic period. Inflation, for example, has met the Bank of England’s 2% target in each of the past two months. This should eventually bring a protracted cost-of-living crisis to an end, thereby creating improved operating conditions for consumer-focused UK firms as disposable incomes rise in real terms.

Lower inflation also means that monetary policy is likely to become increasingly accommodative over the coming months. Once time lags have passed, interest rate cuts should have a positive impact on an economy that has already bounced back from recession to expand by 0.7% in the first quarter of the year in what is its fastest growth rate since the final quarter of 2021. Alongside modest inflation and interest rate cuts, this means the prospects for dividend growth among firms dependent on the UK economy are likely to significantly improve.

Seeking a compromise

The recent relative unpopularity of UK-focused income stocks means that valuations are generally low. While this would normally mean that dividend yields are relatively high, growth in shareholder payouts across many industries is likely to have been negatively affected by a tough economic environment. Income investors may, therefore, find it difficult to unearth companies offering a combination of an attractive yield, a modest payout ratio and strong dividend growth prospects.

For example, a company may have decided to reduce dividend payments in response to tough operating conditions caused by a weak economic environment. This may mean it now offers a relatively modest dividend yield. Conversely, another firm may have maintained, or even increased, dividend payments over recent years so that it now has a relatively attractive yield. However, its payout ratio may be very high due to falling profitability.  

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In both cases, income seekers may be dissuaded from investing. But it is important to consider that recent weak economic and company performance is highly unlikely to be repeated over the medium term. Inflation, for example, is extremely unlikely to return to double-digit levels, interest rates are set to experience a sustained fall rather than rise over the coming months, while the economy is widely expected to deliver positive growth, as opposed to a recession, in 2024 and 2025.

Sound fundamentals

Clearly, there are still risks ahead for UK-focused income stocks. For example, the new government has not yet set out its fiscal policy in detail. Changes to taxation could have a significant impact on specific industries, as well the wider economy, while political risks in other countries such as the US may yet have a sizeable influence on the global outlook for GDP growth.

Furthermore, inflation is expected to tick slightly higher in the second half of the current year. This could lead to a slower pace of interest rate cuts than many investors are presently anticipating. And should monetary policy easing take place, the presence of time lags means that its full impact on the economy’s performance may take some time to become clear.

Overall, though, a more stable political environment, modest inflation and the prospect of interest rate cuts equates to an increasingly favourable outlook for UK-focused income shares. Investors who are able to focus on companies that have solid financial positions and a clear competitive advantage, while adopting a long-term view, are likely to experience a worthwhile income return as the UK economy’s performance ultimately improves.

An upbeat income outlook

Housebuilder Taylor Wimpey (LSE:TW.) is a UK-focused company with long-term income investing appeal. It currently has a dividend yield of 6%, which is the highest figure among FTSE 350 housebuilders. It is also 240 basis points greater than the yield of the wider index. This is in spite of the company’s 45% share price rise since first being featured in this column in June last year, with its high yield largely the result of a generous dividend policy that aims to pay out 7.5% of net assets as dividends each year.

Due to a tough operating environment, where demand for new homes has fallen largely as a result of rising mortgage costs and a cost-of-living crisis, the company’s financial performance has come under pressure. In its latest financial year, for example, revenue declined by 21% and pre-tax profit slumped 43% as completions fell by 23% year-on-year. When combined with a dividend that grew by just under 2% last year, this meant that the firm’s payout ratio stood at roughly 97%.

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Clearly, this is exceptionally high and relatively unsustainable over the long run. Taylor Wimpey’s financial performance, though, is likely to improve as demand for new homes increases amid modest inflation, interest rate cuts and a more buoyant economic outlook. This means that its payout ratio is likely to moderate, thereby making dividends more affordable, while shareholder payouts themselves could rise at a faster pace. The combination of a relatively high yield and the potential for growing dividends over the coming years could mean investor demand for the firm’s shares increases.

A favourable risk/reward opportunity

In the meantime, the company’s net cash position of around £584 million means it has sufficient financial strength to overcome potential economic challenges. It also has a strong competitive position, as evidenced by a land bank that amounts to 79,000 plots. And with the company delivering £19 million of annualised cost savings last year, it appears to have a sound strategy through which to overcome short-term economic challenges in order to deliver long-term growth.

Taylor Wimpey’s latest half-year results, meanwhile, stated that it is on track to meet financial guidance for the current year. While the company expects a further fall in completions of around 9% in the 2024 financial year, it is positioned for growth from 2025 onwards. And with its shares currently trading on a price/earnings ratio of just 16 despite its decline in profitability last year and an upbeat long-term outlook, it appears to offer good value for money.

With there being a longstanding undersupply of new homes, housebuilders such as Taylor Wimpey have bright long-term futures. Clearly, there is the potential for policy changes under a new government, as well as an evolving fiscal outlook. But with the company’s shares offering a relatively high dividend yield and still trading around 31% below their pre-Covid level, they appear to offer a sufficiently wide margin of safety at present.

Furthermore, the firm’s dividend growth prospects are likely to improve as a more upbeat economic period takes hold. This should also help to make dividends more affordable and sustainable. When combined with a solid balance sheet and a sound competitive position, the company’s shares offer income investing appeal on a long-term view.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.