Dividend cuts: how income investors can beat the drought

As payouts dry up across the blue-chip landscape and beyond, what can income-seeking investors do to stay afloat and ensure they keep a steady flow of dividends? Tom Bailey explains.

The coronavirus pandemic has resulted in economies around the world going into shutdown, and with economic activity falling, companies have seen their revenues diminish. This has repercussions for their ability to pay dividends.

According to research from ETF provider GraniteShares, 162 UK-listed companies cancelled or suspended payments between 19 March and 20 April. Meanwhile, Link Group’s UK Dividend Monitor report estimates a dividend decline of 51% in its worst-case scenario, while its best case forecasts a 27% fall in dividend payments.

Even stalwart income-producing shares such as Royal Dutch Shell have been hit. The company, which has a record of maintaining payouts stretching back to World War II, has cut its dividend by 66%. Any investor with an income focus is likely to be feeling some pain.

- 10 equity income gems as Covid dividend cuts bite

Dividend doldrums

Unlike share prices, dividends take a while to recover. While share prices have been (at the time of writing) rebounding strongly on the assumption (by no means a certainty) that the worst of the pandemic is behind us, the situation is different for dividends.

Helal Miah, an investment research analyst at The Share Centre, says: “There seems to be some belief among investors that as soon as the lockdown  is lifted and life returns to some form of normality, company dividends will get back to where they were prior to the crisis.” Unfortunately, that is unlikely.

He adds: “On lifting the lockdown, the economy won’t just carry on from where it left off and dividends won’t just resume. Many businesses will disappear permanently, while many people will have lost jobs and incomes among consumers will have taken a dive, as government schemes will not totally compensate.”

Similarly, Mike Coop, head of multi-asset portfolio management at Morningstar, argues that the reinstatement of dividend payments will depend on the depth and duration of the coming recession. He says: “Looking at historic recessions, it will take several years before dividends return to normal levels.”

Income investors should, therefore, expect a dividend drought lasting over the coming months or even years. Here are some key pointers for income investors trying to navigate these difficult dividend waters to keep in mind.

What’s in a cut?

Colin Morton, manager of the Franklin UK Equity fund, says investors should be careful not to tar all companies that cut their dividends with the same brush. He  says: “As active stockpickers, we spend time analysing businesses and identifying the underlying rationales behind announced dividend changes or potential changes to come.”

Morton notes that while plenty of companies with weak, often debt-heavy balance sheets are cutting their dividends, strong companies have also had to scale back payments. He says: “Even companies we view as having good-quality characteristics, including dominant market positions and resilient fundamentals, are currently choosing to forgo dividend payments.”

He puts this down to businesses taking pre-emptive action to preserve cash and keep balance sheets healthy. “This can be a prudent, in our view, and possibly the right thing to do, given the exceptional market circumstances today.”

But investors should not assume all companies cutting their dividends are in a bad position. Instead, they should attempt to familiarise themselves with the financial health of companies they rely on for income. Anyone buying individual shares should already be pretty familiar with the financial position of their holdings.

However, in light of the past few months, it’s worth reassessing the balance sheet strength of the companies you hold. For instance, a company with high debt but solid or growing revenues may have looked strong prior to the pandemic; that same company may now have a highly leveraged balance sheet but have suffered a collapse in its revenue, which could have disastrous long-term consequences for the business.

Such an assessment should indicate when a company will reinstate its payouts. A company that has a lot of debt on its balance sheet may spend the economic recovery, when it arrives, focusing primarily on repairing its balance sheet, and put dividends on hold.

This exercise is broadly what the professional income investors are doing, says John Monaghan, head of research at Square Mile Investment Consulting and Research. He says: “Fund managers are concentrating on the long-term viability of companies and basing their analysis on a firm’s ability to withstand the current crisis. Those funds with a greater emphasis on dividend sustainability and those that are more conservatively managed have held up well and, in some cases, fallen by far less than the FTSE All-Share index recently.”

The dividend heroes have payments covered

Notes: *Dividend cover shows the number of years a trust could pay current dividends entirely out of its reserves. Source: AIC/Morningstar, as at 29 April 2020.

Sector selection

Another way to find dividend resiliency is to seek sectors that will hold up better under the present conditions. As Laura Foll, manager of Lowland investment company, notes: “The question for income investors has now become: which sectors are likely to pay dividends, rather than which sectors are likely to suspend them?”

Foll adds that she expects traditionally defensive sectors such as pharmaceuticals and utilities to continue to pay their dividends.

Monaghan suggests that the sector choice of the managers of Troy Trojan Income fund – which has achieved a rising level of income in all bar one of the past 15 years – is worth noting. He says: “They prefer companies that have resilient franchises such as pharmaceuticals, household goods, and food and beverage producers. Companies in these sectors are likely to perform better under current circumstances than those that are under-represented in the fund, such as commodity-related companies, house-builders and airlines.”

Job Curtis, a fund manager at City of London Investment Trust, also emphasises the importance of defensive stocks for those trying to produce income. He says: “Defensive holdings – such as consumer staple companies and utilities, where there is, in our view, the least danger to dividends in the portfolio – were recently added to.”

Meanwhile, some sectors look likely to take a relatively long time to recover. Coop identifies companies in the oil sector, which have suffered from the  unprecedented slump in oil prices during the current crisis, as examples. He says: “Energy is going through a period of structural decline. There is increased competition on supply, while we are now left with a cyclical collapse in demand.

“Oil prices are just too low for the industry as a whole, so you will see companies cutting capital expenditure, exploration and non-essential payouts such as dividends.”

His view is that ultimately what happens will depend on the path of oil prices. We should expect to see some sort of rebound in prices at some point, but when is anyone’s guess. “This could go on for some time; prices certainly won’t bounce back this year.”

Foll, however, says that even companies in hard-hit sectors such as industrials and house-builders may still be a good bet for income investors, as long as their balance sheets remain strong.

Industrials and house-builders, she notes, should bounce back strongly when economic activity troughs and then recovers. As long as their balance sheets emerge relatively intact, they should be able to start repaying dividends. She says: “Many companies [in these sectors that we hold] went into this with already strong balance sheets, having learned the lessons of the financial crisis.”

Look beyond UK equities

For many years, dividend-seekers have been prompted to look beyond the UK for income. But with the UK offering generous yields, many investors have ignored this advice. Coop says: “Investors in the UK have got used to a Wile E Coyote situation of running off a cliff and being suspended in mid-air, with dividends payments holding up more than they really should have.”

This situation has been risky for income investors. Coop notes that the dividend payout ratio (which indicates what proportion of a business’s net income is paid out in dividends) for many UK companies pre-coronavirus was dangerously high. At the same time, the dividend concentration of the FTSE 100 index has been high, making UK investors increasingly reliant on a few big names.

Such arguments have also been made by prominent income investors, including Liontrust’s Robin Geffen, who observed pre-pandemic: “The payout ratio is the highest I can remember in my lifetime.”

Coop advises investors to “try to not be beholden to certain companies and their payout ratios”. This can be achieved by looking at dividends abroad. While companies in emerging markets and Asia have historically been less generous dividend payers, corporate governance in these regions has improved substantially over recent years, and greater consideration is now given to shareholder remuneration.

On top of that, many companies in emerging markets are transitioning from a period of rapid growth (when they were using large chunks of their cash flow for expansion) to a more mature phase during which shareholders are more likely to be given any extra cash. As a result, dividend payments in emerging markets have been growing fast.

With Asian markets generally holding up better than developed economy markets in recent months, income investors with exposure to the former will have benefited from a most welcome diversifier.

Coop says: “This is another way to diversify your sources of income and thereby reduce the risk of dividend cuts.” He also points to the importance of looking beyond equities alone for income, towards the high-yield bond markets in the US and Europe. He says credit ratings there “still look decent”.

He adds: “There has also been a sell-off, so prices are not too high and therefore compensate for some of the risk you are taking on.” He goes on to note that while defaults might go up, governments and central banks around the world are doing their utmost to preserve liquidity in credit markets.

However, it is very important that anyone looking to rejig their portfolio due to dividend cuts does not recklessly chase yield. The higher the yield on an asset, the riskier it is. A large yield suggests that the price of the asset has fallen, reflecting market uncertainty about the asset – in many cases with good reason.

Trust cover

For those opting for actively managed funds to gain access to income, the crisis is a good reminder of one of the key benefits of investment trusts: their ability to hold back reserves in better times to pay out in difficult periods, such as now. As Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), notes: “Unlike open-ended funds, investment companies don’t have to distribute all of the income they receive from their portfolios but can save some for tougher times.” Trusts can hold back up to 15% of their income each year.

Already, popular trusts such as Alliance Trust, F&C Trust and Henderson International Income have announced their intention to dip into their reserves to support dividend payments.

In terms of levels of reserves, most income-focused trusts have enough reserves to cover at least a year of their dividend payments. Data from the AIC shows that the median reserve dividend cover for the UK equity income sector is 1.26 times. A dividend cover of 1 times would mean a trust has enough reserves to cover a year of payments, even if all dividends from underlying holdings were suspended for a year.

Dividend heroes, as you might expect, generally have higher dividend cover, as the table shows. The Scottish Investment Trust has a cover of over 3 times, meaning that it could pay its current dividend for three years out of its reserves.

Don’t look back

It is vital that investors are fully aware of what they are looking at when they assess the income potential and yield of funds. The yield figure for many funds will no longer reflect reality, as it was based on  a snapshot of the yields from the fund’s holdings over the previous 12 months. With the recent sudden surge in dividend cuts, that figure won’t reflect current circumstances. The actual yield of the fund in the near future is likely be far less than the historic yield.

On top of this, the Investment Association has suspended the income yield requirements for its equity income sectors for 12 months, due to the recent spate of dividend cuts. As a result, many funds currently producing a much reduced payout will remain in its sectors for now.

Income takeaways

Do’s
If you’re investing in individual equities, assess the balance sheet strength of companies you hold. Weak balance sheets indicate that a return to dividend payouts could be a long time coming.

Look beyond UK equities, whether that’s to the increasingly generous payouts from emerging market and Asian companies or to different income-producing asset classes.

Don’ts

Considering seeking new, higher-yielding assets? Don’t chase yield or take on excessive risk. High yields on other assets are generally high for a reason.

It’s important to remember that the dividend cuts currently being seen mean annual yield figures for funds will not reflect the new reality. Be sure you know exactly what you are looking at.