There may be a silver lining to the cloud hanging over income
More sustainable dividends
For the first time in modern history, the world has experienced a synchronised shutdown of the majority of economic activity and the enforced quarantine of almost entire populations. This situation has created an unprecedented dilemma for companies, with large numbers of them withdrawing completely from providing any estimate of their future sales and profits.
Ordinarily maintaining dividends would be a priority for management teams, but we are in extraordinary circumstances. Even companies with hitherto conservative and appropriate levels of financial gearing have faced difficulty in these exceptional economic circumstances. This is leading them to reassess dividends, which are usually considered a measure of a company’s strength, prestige and dependability, nowhere more so than in the UK. In this environment management teams have been erring on the side of caution and suspending dividend payments.
Seeking total returns
The UK market is uniquely focused on dividend income, which has contributed significantly to total returns. In the US, for example, there is a much greater focus on returning capital to shareholders through share repurchases as well as dividends. The UK market has also relied on a handful of large dividend payers, with the top five representing 34% of total dividend payments in 2019, and the top 15 representing 64%.
Many of these companies are in sectors with relatively little structural growth, like oil, mining and banking. Those three sectors are all cyclical, or sensitive to economic cycles, so the broader economic outlook will be critical in determining their future dividend policies.
"Provided we don’t see a significant second COVID wave and renewed lockdowns, we think many companies that have suspended dividend payments will resume them later in 2020 or in 2021."
Dividends for the FTSE All Share are expected to fall 34% from 2019 levels, according to analysts’ consensus (figure 3), which would put the current yield at 3.5% . While we think UK dividends will fall more than this, the yield will still be attractive compared with other asset classes and other equity markets. Provided we don’t see a significant second COVID wave and renewed lockdowns, we think many companies that have suspended dividend payments will resume them later in 2020 or in 2021, albeit in many cases at reduced levels. Consensus estimates are that dividends will rebound by 23% in 2021 to yield 4.3%.
Papering over the cracks
In many cases, favoured UK income stocks across different sectors had high initial dividend yields but little prospect of dividend growth. 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. Few companies felt they could cut their payouts without causing an unwanted fall in their share prices.
For better long-term income and returns, we strongly believe that dividend growth potential is more important than the absolute level of current yields. How businesses allocate their capital ultimately determines the level of their future profits and also whether those profits can be sustained. The cash returned to shareholders should be the by-product of prudent, sustainable investment in a business. It shouldn’t be the overarching aim.
There is a possible silver lining to this pandemic. So much has happened that was out of companies’ control. Yet, ironically, this could give companies more control in the future. It could be a perfect excuse for companies to reset their strategies, their investment plans and their dividends in order to offer more sustainable and attractive long-term growth and income.