UK Equity Income – 3 share ideas for dividends

Lloyds Banking Group

A large part of the investment case for Lloyds is its heavily discounted valuation, which is currently sitting well below its long-run average.

The depressed valuation has pushed the forward dividend yield up to an attractive 7.0%. Backed by a strong balance sheet, we think this creates the potential for further returns from share buybacks too. But remember, no returns are guaranteed and yields are not a reliable indicator of future income.

Lloyds' focus on traditional banking does make it more exposed to the traditional interest rate cycle than others – 73% of total income was from interest at the last count. With its interest income booming over the past year or so because of rising rates, things seem to have peaked.

Mortgages issued over the pandemic are coming up for renewal at less profitable levels too. This has been a headwind heading into 2024 but should tail off towards the end of the year.

The main drawback of Lloyds' business model tends to be the higher-than-average exposure to potential loan defaults. But with no real uptick in arrears, even these have stayed lower than many first thought. That might change, but the economic outlook is starting to show signs of improvement – with unemployment rates holding firm, house prices stabilising and real wages rising.

Lloyds boasts one of the higher quality mortgage portfolios, which we see as more resilient than most peers. There’s also the benefit from the structural hedge to come through – think of this like a bond portfolio that’s set to roll onto better rates in the coming years. This looks set to boost income over the medium term.

We see the group’s depressed valuation as an attractive entry point. Lloyds is our preferred name in the sector, given what looks to us like a stronger operation than some peers. But it’s not immune to economic uncertainty, so be prepared for a bumpy ride.

Primary Health Properties

Primary Health Properties (PHP) invests in purpose-built doctor’s surgeries with a long track record of delivering results for shareholders. The group’s even earned the right to call itself a dividend aristocrat, now in its 27th consecutive year of dividend increases.

As a REIT (real estate investment trust), PHP must pay out most of its profits as a dividend. That translates to a forward dividend yield of 6.8%. Although, no shareholder returns are guaranteed.

PHP’s asset base is relatively defensive in the context of today’s uncertain macroeconomic environment. Rent collection rates were 99% in both 2021 and 2022, with 2023 rates trending in the same direction.

We think PHP has several features that underpin long-term dividend-paying potential. The NHS backlog and an ageing population means investment in primary care facilities isn't going anywhere.

And, with 89% of the group's rent roll funded by the NHS or its Irish equivalent, we view the group's tenants as lower risk. On last count the average lease length stood at 11 years, meaning rental income should be secure for years to come.

There are reasons to be cautious though.

Loan-to-value (LTV) is high by industry standards and has risen over the past year.

The REIT structure means investors are likely to be asked to fork out extra cash from time to time, especially as debt financing is more expensive because of higher interest rates. And, because REITs have to pay out most of their profits it's difficult for them to fund growth organically.

PHP’s valuation has come down a little over the past 12 months and is now broadly in line with its peer group. The prospective dividend yield is attractive, and with interest rates expected to fall in 2024, the value of the group’s properties could get a welcome boost, although there are no guarantees.

Taylor Wimpey

With all the uncertainty floating around the UK economy right now, it might seem odd to pick a housebuilder, given their cyclical nature. Rising interest rates, higher inflation, and regulatory challenges have created significant pain for the sector in recent years.

While there are probably further difficulties ahead, there are also early signs that pressure in the sector is easing. Softer inflation figures are coming through, and lenders are becoming more competitive on mortgage rates – both of which improve buyer affordability and have the potential to increase sales rates.

With its valuation currently sitting well below its long-run average, we think Taylor Wimpey is well-placed to benefit when the market finds its feet again.

The group also has a healthy forward dividend yield of 6.5%. With its current dividend policy related to asset value instead of earnings, it means investors could get a base level of dividends even if economic conditions stay difficult. But remember, dividend policies can change without warning, and no dividends are ever guaranteed.

The balance sheet’s in very good shape, possibly one of the strongest in its peer group. With net cash of £678mn on hand, there’s a big cushion there to help smooth any bumps in the road.

But there are still plenty of challenges to navigate.

2023’s operating profit is set to fall roughly 50% from the £907.5mn seen in 2022. That’s led Taylor Wimpey to pull back on new land spending, which we expect to be the case throughout this year.

The sector’s also facing ongoing labour and supply chain challenges, with planning permission disruptions continuing to be a thorn in the group’s side.

All in, the UK housebuilding sector has had a bit of a recovery in late 2023, meaning investors should be focussed on the longer-term outlook. But, the valuation and income-generating potential is still attractive to investors. Given its strong financial position, Taylor Wimpey is one of our preferred names in the sector.