UK Equity funds look forward to 2010

UK equity income fund managers will not be sorry to have put 2009 behind them. The FTSE 350 Higher Yield index underperformed its FTSE 350 Lower Yield counterpart by 26.5% during the year, returning just 12.7%. Dividend cuts for 2009 are expected to come in at around 15%, leaving UK equity income managers with a much depleted pool of stocks.

Markets in December showed signs of a long-awaited change in sentiment. The Higher Yield index was up 3.8%, compared to a rise of just 3.1% for the Lower Yield index. The trusty dividend stocks, such as the oil majors, telecoms and pharmaceuticals, have been out of favour for some time and many are now saying they look undervalued. A number of companies are producing a higher yield on their equity than on their corporate debt – a rare anomaly.

Meanwhile, a recent survey by Deloitte’s has suggested finance directors are the most optimistic they have been for two years. They are increasingly willing to take financial risk while worries on liquidity have faded. As these are the people who hold the purse strings, it suggests the worst might be over for dividend cuts. Market consensus is suggesting dividends will start to rise again in 2010.

Dividend stocks may also benefit from the weakness in sterling. Approximately 40% of dividends come from companies reporting in dollars and these are seeing their earnings flattered by the falling currency.

However, there are still some companies where the dividend is seen as vulnerable, the most notable being United Utilities. Merrill Lynch analysts issued a critical note on the company, forecasting a dividend fall of 20%, which hit the shares during the month. Equally, the Basle Committee on banking supervision threatened to block banks from paying dividends where they didn’t meet certain capital adequacy criteria, making a return to the days of high payouts unlikely.

There are still worries over the concentration of income stocks, with a huge chunk of the available dividends coming from just a few companies. As a result, managers are tending to look down the market capitalisation scale or abroad to diversify their income stream.

The average UK Equity Income fund returned 24.59% in 2009, which was just over 5% behind the UK All Companies sector. It was ahead of the UK Income & Growth sector although this still looks better over three and five years. Ultimately, managers in the sector will be hoping that 2010 brings a change in fortunes.