The under-the-radar income shares the pros are backing

Fund managers tell Kyle Caldwell the stocks they are finding value in that are not among the biggest dividend-paying firms in the UK and globally.  

The UK market has both a rich dividend heritage and an attractive dividend yield to boot, with UK shares yielding around the 4% mark on average.

However, for investors backing the UK for income, it is important to be aware that it is the biggest FTSE 100 firms that generate most payouts for the market as a whole.

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The widely followed Link Dividend Monitor shows that the top 15 dividend stocks in 2022 accounted for 60% of total dividends, and were dominated by oil companies, miners, tobacco, banks and healthcare stocks.  

The top five income payers, responsible for 28% of all payouts, were Rio Tinto (LSE:RIO), Shell (LSE:SHEL), British American Tobacco (LSE:BATS), HSBC (LSE:HSBA), and Glencore (LSE:GLEN).

While these big blue-chips are generally reliable payers – with miners being an exception – the data from Link shows faster dividend growth in 2022 was achieved among mid-cap shares in the FTSE 250 index, which delivered underlying dividend growth of 23.8% versus 14.8% for the FTSE 100. Link notes “this reflects the ongoing recovery after the steep cuts made during the pandemic”.

Smaller-company income plays

Therefore, the mid- and small-cap part of the market, which contains more domestically focused stocks, is where investors can potentially find higher dividend growth. However, the risk is that companies may view the dividend as an unnecessary luxury for shareholders in the face of trying to grow their businesses while contending with sluggish economic growth, high inflation and rising interest rates.

However, data from fund manager Octopus Investments shows that dividend cover, a key metric for the sustainability of payouts, is broadly the same for the FTSE 100, FTSE 250 and FTSE Small Cap, at 2.4x, 2.4x and 2.5x.

In its view “the FTSE 100 is dominated by established companies that have limited growth opportunities and pay out the majority of profits as dividends, as opposed to reinvesting them. This can lead to poorer levels of sustainable growth.”

In addition, Octopus Investments says that investors do not have to sacrifice much in the way of dividend yield for the potential higher dividend growth in future years. It points out that the FTSE 100 is expected to yield just over 3.9%, but other indices are not far behind. The FTSE 250 (excluding investment trusts) is expected to pay out a 3.4%, and the FTSE Small Cap (also without investment trusts) is forecast to yield 3.8%.

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Octopus Investments’ Quoted Funds Team names two under-the-radar income picks from the mid-cap and small-cap parts of the market.

The first is Intermediate Capital Group (LSE:ICP), a global alternative asset manager, which is listed in the FTSE 250. It has seen growth in its ordinary dividend for 12 consecutive years. For this financial year, Octopus Investments says the business is expected to generate a five-year dividend compound annual growth rate of almost 22%. The dividend yield is over 6%. 

Octopus Investments’ second pick is translation services specialist RWS Holdings (LSE:RWS). The AIM-listed stock has 17 years of unbroken dividend progression. Octopus Investments says the stock has a five-year dividend compound annual growth rate of 10.8%. The dividend yield is 3.5%. 

Ken Wotton, fund manager of Strategic Equity Capital (LSE:SEC) investment trust, also prefers to look beyond the big income stock payers. He points out that as inflation skyrocketed in 2022, investors had to work harder to find income, leading many to oil and mining stocks. While dividends soared last year, the outlook for this part of the market is less rosy in 2023.

As interactive investor recently noted, the typical UK equity income fund has 5% to 10% in mining stocks. However, the sector is not historically a reliable dividend payer. Mining company dividends fluctuate depending on the performance of the iron ore price. In addition, some firms have strict dividend payout ratios. As a result, if they make less money, then the dividends are cut.

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At the end of last month, falling iron ore prices led BHP (LSE:BHP) to cut its interim dividend from $1.50 per share to $0.90, while Rio Tinto (LSE:RIO) reduced its dividend from $4.17 to $2.25. Rio’s policy is to pay out 60% of adjusted earnings. Anglo American (LSE:AAL), meanwhile, reduced payouts from $1.18 to $0.74. This is in line with its 40% payout policy. 

Wotton says: “These cyclical sectors are prone to volatility, as evidenced by dividend cuts during Covid-19, and the future of fossil fuels is a foregone conclusion. Instead, investors should look to other areas that can consistently deliver robust dividends. We target companies in structurally growing sectors, with a competitive advantage providing them with prolonged pricing power.”

His two under-the-radar income picks are Inspired (LSE:INSE), the energy advisory and sustainability services firm, and XPS Pensions Group (LSE:XPS), which provides specialist advice to defined benefit occupational pension schemes. The respective dividend yields are 2.5% and 4.6%.

Wotton says: “Inspired helps its clients rise to the growing imperative to operate more sustainably – requirements that will only become more demanding – but also to manage their energy consumption more efficiently. This is crucial to clients given the elevated levels of energy prices.

“XPS Pensions Group operates in a large and structurally attractive market providing specialist advice to defined benefit occupational pension schemes; demand is robust and growing because of regulatory drivers and the increased complexity of running these schemes.”

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Neil Hermon, fund manager of Henderson Smaller Companies (LSE:HSL) investment trust, also hunts for income opportunities in the mid-cap and small-cap parts of the market. The trust, a member of interactive investor’s Super 60 investments ideas, has raised its dividend for 19 consecutive years. Its dividend yield is 2.9%.

In a video interview with interactive investor last December, Hermon named buy-to-let lender OSB Group (LSE:OSB), and speciality chemicals business Victrex (LSE:VCT), as two examples of income stocks outside the FTSE 100 that he favours. The respective dividend yields are 5.6% and 3.5%.

Under-the-radar global income picks

For investors looking overseas for income, there’s not the same concentration issue, as the top 20 dividend payers in 2022 accounted for 17.7% of all global dividend payments, according to analysis by Janus Henderson.

The 10 biggest global dividend payers last year were: BHP Group (LSE:BHP), Petroleo Brasileiro SA Petrobras (NYSE:PBR), Microsoft (NASDAQ:MSFT), Exxon Mobil (NYSE:XOM), Apple (NASDAQ:AAPL), China Construction Bank (SEHK:939), Rio Tinto (LSE:RIO), China Mobile (SEHK:941), JPMorgan Chase & Co (NYSE:JPM), and Johnson & Johnson (NYSE:JNJ).

Neil Denman, portfolio manager for global equity income strategies at Sarasin & Partners, looks for “structural income winners”, which he says are dividend-paying firms that can deliver added value.

He says: “How much added value a business can deliver can often be gauged by the amount of research and development (R&D) it conducts. After all, the purpose of R&D is to develop new products that can be sold at attractive margins. This also helps offset inflation.”

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Three stocks he highlights are: Siemens (XETRA:SIE), Cisco Systems (NASDAQ:CSCO) and Merck & Co (NYSE:MRK).

And finally, Robert Strachan, investment analyst at Evenlode Investment, names Sonic Healthcare (ASX:SHL) and Wolters Kluwer (EURONEXT:WKL) as two global income stocks that are under the radar.

He says that Australian medical diagnostics firm Sonic Healthcare has a “consistently healthy dividend” due to its “localised market dominance”.

Commenting on Dutch information, software and services company Wolters Kluwer, Strachan says that its attractions include “good organic growth and a growing share of subscription revenue”.