Dividend drought: how severe will UK equity income payout cuts be?

Dividend distributions from UK equity income funds could fall by as much as 45% in 2020.

Until the Covid-19 outbreak, UK companies had a well-established reputation for paying high and consistent dividends. However, the pandemic has prompted companies to take an axe to payouts to shareholders in favour of conserving cash: UK dividends plunged 57% in the second quarter of the year with three-quarters of companies cutting or cancelling their dividends. 

For those who rely on an income from their investments, this is unsettling. Even the UK’s dividend stalwarts have cut payouts, notably in hard-hit sectors such as oil and gas, or politically sensitive areas such as banks. The make-up of the UK market has not helped. Dividends in the FTSE All-Share index are highly concentrated, with 37% of all payouts coming from just five stocks, of which three have cut or cancelled their dividends (HSBC (LSE:HSBA), Royal Dutch Shell (LSE:RDSB) and Lloyds (LSE:LLOY)). 

There is an argument that active funds may not take the full force of cuts. After all, a robust investment selection process should be able to root out those companies that have temporarily put dividends on hold and those where they are permanently impaired. Equally, they should naturally exclude companies with weak dividend cover, excessive debt, stretched balance sheets and so on. 

Consulting group Square Mile did a survey of fund managers in April. John Monaghan, head of research at Square Mile Investment Consulting and Research, said these managers predicted a 40% to 45% reduction in UK dividends. He adds:

“We are working off the assumption that income distributions from UK equity income funds could fall by a similar magnitude.”

This suggests that while it is possible for many equity income fund managers to navigate the crisis better, many have not, and investors may see chunky falls in their income this year. This reflects a long-held criticism of the UK equity income sector that managers tend to derive the majority of their income from a narrow range of companies, as happens in the index. If those companies do badly – as the banks did in 2008-09 and oil and gas companies have done in this crisis – the sector suffers. 

Unfortunately, the weakness in dividends has also had a knock-on effect on the capital values. UK equity income funds have performed worse than any other sector for the year to date, down 21.3% on average to 10 August, according to FE Analytics. This compares to a drop of 17.9% for the UK All Companies sector and 13.8% for UK Smaller Companies. 

For Robin Geffen, manager of the Liontrust Income fund, the two elements are related:

“Whether an investor has put his or her money into a fund to take the income or a total return, dividend cuts have a detrimental effect. Not only do dividend cuts mean that investors in these companies suffer a loss of income but there is also generally a negative impact on their capital values.”

This is a gloomy picture, but it is worth noting that some managers have managed to sustain income and capital in this environment. The best-performing fund in the sector year-to-date – the LF Miton UK Multi Cap Income – is down just 4.1%. In contrast, the worst year-to-date performer is down -33%, which is the UBS UK Equity Income fund. In general, managers that have looked beyond the traditional dividend stocks and sectors have put themselves in a better position. 

Geffen is clear that many company dividends looked vulnerable long before the crisis: “There was complacency early in the year about the ability of many companies to maintain their levels of dividends. The spread of Covid-19, the lockdown and the consequential economic impact have accelerated a trend that we had been warning clients and investors about for the previous year. This was the fact that some very high-yielding companies in the UK had not had the earnings capacity or dividend cover to support their levels of income.” Good active managers should have been alert to this. 

From here, selectivity will be vital. Geffen says: “Some companies have increased their dividends and others have recently reversed decisions to suspend or cancel their payments. More than ever, investors should be selective about which companies they invest in for income.” He adds that certain sectors will continue to struggle, notably industrials, airlines, leisure stocks, hotels and retailers. “But there will be winners even in the most difficult sectors such as retailers. Tesco, for example, has significantly increased its online sales this year,” says Geffen.

Peel Hunt analysis shows that around £1 billion of dividends have already been restored as companies such as Land Securities (LSE:LAND), Smurfit Kappa (LSE:SKG) and BAE Systems (LSE:BA.) have come back to the market.

However, BP's (LSE:BP.) cut, announced at the start of August, is a reminder than companies are still facing considerable uncertainty. 

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Monaghan says that companies have generally cut dividends for one of three reasons: they do not have the cash on their balance sheets to maintain previous payout levels; they would prefer to preserve cash in order to help them weather future uncertainty or they have been “encouraged” by the government to reduce dividends to ensure that they are sufficiently capitalised to meet their regulatory obligations.

He adds: “In our survey, the consensus estimates were that 50% of UK dividend cuts in 2020 would likely be done as a precautionary step, 30% would be for financial reasons and 20% for political reasons.” The best fund managers have focused on the first group, avoided the second group and picked selectively amid the third group.  

To find fund managers doing the right thing, investors need to get under the skin of the companies in a portfolio to see where they are invested. How closely does their portfolio just match the 10 big dividend payers in the market – HSBC (LSE:HSBA), Royal Dutch Shell (LSE:RDSB), GlaxoSmithKline (LSE:GSK), British American Tobacco (LSE:BATS), Lloyds (LSE:LLOY), BP (LSE:BP.), Rio Tinto (LSE:RIO), InterContinental Hotels (LSE:IHG), Prudential (LSE:PRU) and Reckitt Benckiser (LSE:RB.)? Does the fund manager appear to be looking more creatively for income? 

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Another problem for investors to navigate when selecting equity income funds is that yield figures quoted are no longer particularly useful. Yield is a backward-looking measure and only reflects dividends that have been paid in the past.

The quoted yield for a fund will not give a picture of likely cuts to investor payouts in the future. 

Monaghan says:

“A number of managers who we have spoken to over the past four to five months have reported that historic yield numbers are currently very misleading, as, given the immediate backdrop for dividends, the metric is highly unreliable. That being said, this is unlikely to remain the case ad infinitum and, as companies look to rebase dividends and then seek to increase them into the future, there will become a time when the measure will be a more reliable indicator for future income.”

A final question is whether investment trusts could do better. After all, many have squirreled away dividend reserves, which can be employed in a dividend drought to shore up payments to investors. They also have greater investment flexibility. The closed-ended structure means that they are not having to manage inflows and outflows, which allows investment trust managers to search more flexibly for income. That said, in aggregate, the UK equity income investment trust sector has performed worse, down 24.1%.

Monaghan says:

“For open-ended funds, the effects of dividend cuts will feed through to unit holders in the current financial year, whereas investment trusts offer additional flexibility around income distributions. There is the potential that dividend cuts from the underlying companies could have less of an impact for investment trusts. However, investors should be aware that some highly geared investment trusts may have loan covenants requiring them to cut dividends to service debt.”

Ultimately, investment trusts will still take the hit; it is just that the payouts will be “smoothed” for investors. That said, an income-seeker facing a 40% hit to their income may rather this were the case. For open-ended funds, it has been a tough year, but some fund managers have found ways to shore up income and preserve capital even in a tough environment for income stocks.