Paul Burgin looks at the impact of BP cutting its dividend on the Equity Income sector.
Advisers are divided over the impact of the BP oil spill, which the company said today led to a loss of $17bn for the three months between April and June - a UK record.
The oil giant announced in June it was suspending dividend payments until at least 2011. Dividends will remain suspended for the second and third quarters of the year. BP says the board will consider its position on future payments when it issues its fourth quarter results in February 2011.
With BP dividends accounting for around £1 in every £7 of share payouts from UK blue-chip firms, what affect will the disaster have on funds in the Equity Income sector?
Tim Cockerill of adviser Ashcourt Rowan thinks that the BP issue should not affect the ability of the best funds in the sector to reach the revised hurdle.
He says: "BP has shaken managers and highlighted one of the dangers of dividends being paid by just a small bunch of companies. Funds have already cut yields and this could force them to cut again. But as the FTSE yield will also fall as a result, the hurdle will be lower."
Cockerill is keeping a close eye on the reformed sector, concentrating his research on funds that maintain a pure income focus. He likes the Schroder Income Maximiser, Rathbone Income, Liontrust First Income and Newton Higher Income funds.
He says: "They all have traditionally focused on income. They have all rebased their yield expectations and have or will cut income at some point. But they still have income generation at their core."
He also likes the Unicorn UK Income fund that looks for income in smaller caps, thus providing an additional source of diversification for equity yield hunters.
Other Equity Income managers with larger exposures to BP could see their own yields drop 0.5% as a result of the suspension.
Jupiter Income fund manager Tony Nutt has also questioned how well overall yields will recover when BP resumes payments. He thinks managers should not assume that BP's dividend will be reinstated next year, or that it will be paid at its previous level.
Equity Income funds tend to be amongst the most reliant on BP for income, according to Best Invest data. 35 funds in the sector had exposure of 6% or more to the oil company at the end of June. Ten of those funds had exposure of 8% or more. The largest weightings were held by S&W Munro, M&G Dividend and Prudential Equity Income.
Bestinvest says some funds could be forced sellers of BP, even though its share price has fallen to levels last seen in 2002. As their mandates require them to hold shares that yield more than the FTSE, they may have to sell at a loss.
Adrian Lowcock at Bestinvest says: "Those with significant holdings in BP will also have to look elsewhere for their income, perhaps in riskier stocks further down the capitalisation scale."
Thomas See, manager of the Schroder Income Maximiser, says the cancelled dividend will have real consequences for income seekers. Luckily for him, his fund can come at the BP issue from a different angle.
The fund aims to generate a 7% annual yield by combining dividend income with a call option strategy. The strategy sells potential capital gains upside on certain equities in return for an upfront income payment.
See says: "In other words, we do not have to sell out of low or non-dividend paying stocks at any price in order to maintain our yield. Equally, we can actively select non-dividend paying stocks that offer attractive total return - just as we did last year with the banks."
He has been underweight BP for some time, recently increasing his exposure as others have or are forced to cut back. He has generated a yield on the stock by selling three month call options on his holdings. The latest sale generated a premium of 1.6%, equivalent to 6.4% per annum in return for a strike price of 142%. Should BP's share price recover in the next three months, he could make an upside gain to a maximum 42%.
There are also plenty of other stocks for managers to look at. Bill Mott, manager of the PSigma Income fund, says yields have generally risen recently as UK equity prices have dropped back.
If bond market pricing indicates very low growth and inflation, even a double dip recession, Mott says defensive economically-insensitive sectors represent an outstanding investment opportunity. He says: "I cannot recall a time when these stocks have offered such excellent relative values."
His defensive positionings include overweights in telecommunications, which represent 10% of the fund versus 6.12% of the index. Utilities represent 12.2% of the fund versus 3.9% of the index. He also has overweights in pharmaceuticals and biotechnology, tobacco, and food and drug retailers.
[asset_library_tag 1568,Funds' exposure to BP]
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