The pandemic and the global lockdowns to combat its spread have raised havoc with UK dividends. Yet that very disruption could lead to better managed companies and more sustainable dividends, argues Income Fund manager Carl Stick.
There’s a point in 12 Angry Men when 11 jurors vote guilty and Henry Fonda becomes a holdout. Everyone believes the man on trial is guilty, the evidence is undisputed. They all want to get the job over and done with and get to the baseball match. Yet Fonda, annoyingly, refuses to budge.
These days, as an equity income investor, I feel a lot like Fonda’s Juror 8. I feel like I need to give account of why I think the prosecution and all the other jurors are wrong about UK dividend stocks.
"I believe 2020 must be the impetus to redefine what equity income means. Equity income isn’t dead. But quixotically chasing dividend yield most certainly should be."
Concerns about the future of UK equity income started in the Before Times, the pandemic and its consequences have simply upped the ante. Yet I believe the shock of the pandemic will actually deal with the underlying issue that has dogged UK dividend-payers for years. At root, the UK Equity Income sector’s commitment to outdo the yield of the FTSE All-Share Index became a problem when the yield of that index became unbalanced and unsustainable. For many years, the UK has been the go-to market for dividends and companies did their utmost to provide.
Yet a confluence of falling interest rates and seismic shifts in industries that accounted for a large part of the FTSE led many UK companies to come unstuck in their quest for ever-increasing payouts. Broadly, many of them raised cheap debt to paper over the cracks in cash flows, creating an unsustainable path that contorted their balance sheets and curtailed their ability to reinvest in their businesses. Back in 2017, the IA had to loosen the UK Equity Income yield requirements because the index yield began to balloon as the dividends paid by many large companies looked dicey. Few companies felt they could cut their payouts without causing an almighty fall in their share prices.
And then the pandemic came. Many of these businesses were forced to reduce, defer or cancel their dividends. For some, this was inevitable: if your market is closed, if your customers are in lockdown, you cannot generate revenue, so you can’t make profits. Then there is the moral question about paying cash to shareholders when staff are on furlough. So much has happened that was out of companies’ control. Yet, ironically, this could give companies more control in the future. The pandemic is a perfect excuse for these companies to reset their strategies, their investment plans and their dividends.
"For too long in the UK there has been too great a concentration of dividend income being generated by too few stocks, many of which have been anchored to maintaining these payouts regardless of other priorities and – in some cases – common sense. "
How businesses allocate their capital ultimately determines the level of their future profits and also whether those profits can be sustained. Those sustainably growing profits are the bedrock for a sustainable, growing dividend. The cash returned to shareholders should be the by-product of prudent, sustainable investment in a business. It shouldn’t be the overarching aim that then determines how a business deploys its capital; that leads to over-indebtedness and an insidious squeeze on reinvestment that snowballs down the years. I think UK dividend-payers will now be able to reset themselves and enter an era of more sustainable dividends for their shareholders.
My defence of UK equity income is established upon an honest reckoning of the ill-discipline that has accompanied the cash returns to shareholders over the past decade. Cheap funding enabled businesses to over-distribute cash, while ignoring the investment needed to lay the foundation for future growth. For too long in the UK there has been too great a concentration of dividend income being generated by too few stocks, many of which have been anchored to maintaining these payouts regardless of other priorities and – in some cases – common sense.
I believe 2020 must be the impetus to redefine what equity income means. Equity income isn’t dead. But quixotically chasing dividend yield most certainly should be. As for Juror 8, he turned out to be right in the end: the evidence was circumstantial, other jurors were conflating the crime with problems in their own lives and the case wasn’t as clean cut as it first seemed.
Give it a little time, and I feel the charges against UK equity income will also come unstuck.