Dividends remain an import source of shareholder return. Dividends are the cashflows, or after-tax profits, that a company will pay out to its equity shareholders as a reward for owning the shares over time. Once a dividend has been paid out, they cannot be taken back. They are important because they represent a real, tangible return on shares owned.
Covid-19 has prompted suspended and reduced dividends
Covid-19 has raised uncertainty regarding dividend payments in a way that we have not seen before. Companies are seeking out security and liquidity, which means hoarding cash in the bank. In the past, we have seen this in specific sectors, such as the banking sector during the global financial crisis, but we have never seen such a huge swathe of suspensions in such a broad way as we see today.
Research undertaken by Morgan Stanley, highlights that the top 10 companies in the UK market, even though they are approximately 800 or so in the FTSE All Share, paid out approximately 56% of all dividends and the top 20 paid 80% of all dividends. This compares to Europe where the top 10 only paid out 24% of all dividends, which demonstrates the highly concentrated nature of the dividends paid out in the UK market. This means that, when key sectors or key stocks do cut dividends (e.g. Royal Dutch Shell and Mondi), you are going to see that hugely magnified in the market.
Dividend policies may be upended in favour of cash preservation
In the context of an investment, dividends are an important source of shareholder return and can play a key component of investment strategy depending on the need for income and risk tolerance. Dividends tend to be more reliable and consistent than capital returns. The good news is that dividends are here to stay, though the makeup of which companies will be likely to pay dividends will be very different in a post Covid-19 world.
While highly capitalised and cyclical companies may well look attractive from a high yield perspective, the emphasis going forward will be more around cash preservation than on returning it to shareholders. Some sectors that have traditionally paid out high yields are the ones that now find themselves in the most distress. Many companies may well find themselves unable to make high payments going forward, given the changing nature of the environment they find themselves in. For many industries this was already happening pre-Covid-19, and the pandemic may well have only accelerated the process.
Those sectors offering high yields may be tempting but many, like oil & gas, tobacco or telecommunications remain highly competitive and under greater scrutiny, whether from a regulatory, political or an ESG perspective. Some of these industries, particularly multinationals, may be targeted for higher taxation to replenish distressed government finances. In many cases, lower profit growth could well result in dividends being rebased as has already happened in a number of cases, such as BT, Royal Dutch Shell and Vodafone.
Where to look for opportunities?
For those investors comfortable with a lower yield and appreciative of strong capital growth, opportunities do exist. Innovative companies that benefit from the digital age will be clear winners and most likely attract a reallocation of capital. Those with strong balance sheets and positive cash flow characteristics will be best positioned to benefit, given their ability to continue to pay dividends.
Those prepared to shift away from high yielding, but cyclically constrained stocks can find opportunities outside the FTSE100. Companies that in the past have consistently paid out increasing dividends, but also have the tendency to pay out special dividends, given the strong cash dynamics of the underlying business model.
The challenge for investors is to adjust to a world where dividend yields may well be lower, for an extended period. Holding on to high yielders, may not be strategy that pays off, as dividend payments are cut to preserve capital or invest in new projects. A greater emphasis will be placed on those companies that can continue to invest in the long-term future, at an attractive return.
One final point to highlight and to bear in mind, which has become a key trend in recent years, relates to share buybacks. This is the use of surplus cash to buy back stock instead of paying it out as a cash dividend to shareholders. The proportion of companies paying cash dividends has been in long term decline across most developed markets. This contrasts with the number of companies engaging in share repurchase which has trended upwards.
With a de-emphasis on dividend payouts, shareholders may need to reassess their risk tolerance as less predictable capital gains become a more important component of total share returns.
Where will retirement income come from?
Many individuals of course look to dividends for income in retirement: Steve Hunter, head of business development at Seneca Investment Managers considers what the landscape for retirement income generation will look like when we reach the ‘new normal’.
“The phrase ‘new normal’ seems to have entered our vocabulary over the last few weeks, and whilst our day to day lives may look very different for a while yet at some point in the not too distant future we will all begin to move back to a level of normality. Due to a potential decrease in day to day spending the impact for those living on retirement income may yet to be fully seen and its worthy of further thought.
“Since the pension freedoms announcement of 2014, the retirement advice market has seen a move away from annuities with many clients wanting increased flexibility in their retirement options.
“As a result, many of those retiring in the last five years are in the main heavily reliant on investment portfolios to fund their retirement.
“Income requirements are obviously unique to every client but rule of thumb calculations have shown that an income of 4% per annum is potentially a sustainable expectation and with the investment markets of the last few years investors have in the main not struggled to reach and in many cases exceed this expectation.
“Things may have changed though and the recent events across the globe have challenged investment portfolios not only in capital value but also in the generation of income and it is this impact which may be longer felt by those retirees.
“As interest rates have remained low many investors have sought more healthy levels of returns from equity markets and it is this source that may be most eroded as some companies delay or cancel their dividend payments in a bid to bolster their own financials.
“Whilst reducing retirement income levels may not be that palatable, it is a real choice, but are there other potential options to consider whilst remaining within an investor’s tolerance for risk?
“Equity markets are potentially offering incredible value for investors right now and in time will recover so abandoning them completely is perhaps not the best course of action but complementing them with other opportunities could be a way forward.
“A multi-asset approach has seen some investors look wider than traditional equity sources with the inclusion of bonds, property, infrastructure, private equity and other alternatives as a means to broadening the scope for income generation.
“Although not totally immune to the market effects, those who have broadened their sources of investment income are now potentially seeing the true benefits of income diversification.”
Further reading: Companies paying dividends are out there if you look