Investing in companies that pay reliable dividends tended to deliver solid returns, but the Covid-19 contagion has changed all that. Kyle Caldwell writes.
One of the key traits investors look for when buying an investment – whether it be a fund, individual share or exchange-traded fund (ETF) – is some measure of consistency, as this can offer clues to how performance will pan out in future.
For a fund, past performance relative to its peers is the most obvious measure of consistency: it shows how returns have shaped up across and during different market conditions. Similarly, investors in passive funds can measure an ETF’s or index fund’s ability to tightly track a market index by scrutinising its tracking error over different periods. With individual equities, various historic data points are used by fund managers to measure the consistency of financial strength against different economic backdrops.
A simple starting point that has previously proved useful for income investors, highlighted by Money Observer in July 2018, is to look for firms with a reputation for consistent dividend payments. Firms that have increased their dividends for 10 years or more are dubbed ‘dividend kings’. As our piece highlighted, the dividend kings didn’t just deliver on the income front – 23 of the 26 FTSE 100 index companies that at the time achieved dividend king status also came up trumps in terms of superior capital returns relative to the FTSE 100.
Two years on, however, the dividend kings have been dethroned, following widespread dividend cuts in response to the pandemic. Research for Money Observer has re-run the dividend screen to include shares with a 10-year dividend track record to 22 May 2020. The number of dividend kings has been cut from 25 to 14 in the past two months, as a slew of firms have slashed or suspended payouts. There could be more casualties, too, with Johnson Matthey looking particularly vulnerable.
Of the remaining 13 dividend kings, analysis by interactive investor, Money Observer’s parent company, found that just a handful have forecast or seen market anticipation of dividend growth of at least 2% in 2020: Legal & General, Pennon Group, Croda International, Halma and Spirax-Sacro Engineering. Its analysis excluded investment trusts, but on this front, the board of Scottish Mortgage, which has increased payouts for 37 years, announced in mid-May that it would hike its dividend by 4.3%.
Keith Bowman, equity analyst at interactive investor, says: “There aren’t many stocks in the FTSE 100 that boast 10 years or more of continuous dividend growth. Such is the difficulty for investors seeking reliable income from shares.”
He adds: “For most of the past decade, the stock market was in a bull run, which suggested that making money and paying a healthy dividend was easy. Then came the Covid-19 outbreak, which has knocked finely tuned company finances off-kilter as quarantine measures to tackle the pandemic continue to put a strain on UK plc’s bottom line.”
The 11 dividend kings that have cut, suspended or cancelled dividends in the past few months are AB Foods, BAE Systems, Bunzl, Burberry, Compass, Imperial Brands, InterContinental Hotels, JD Sports, Rightmove, SSE and St James’s Place. They are widely spread across different industries, including retail, leisure and travel, and financial services, all of which have been hit hard by the fallout from the pandemic.
These dividend cuts have marred the attractions of the dividend king strategy, which had proved to be a recipe for success over the years in terms of both income and capital returns. Nonetheless, as the accompanying tables show, over 10 years, 13 of the 14 remaining dividend kings have outperformed the FTSE 100 index in terms of both share price and total returns (which include dividends). The outlier is Johnson Matthey, with the shine having come off its share price of late as the market anticipates an imminent dividend cut.
Russ Mould, investment director at AJ Bell, says: “The dividend kings have beaten the index hands down. Their 400% average capital gain compares with 21% from the FTSE 100, while the total return, with dividends banked and reinvested, is 488% – much better than the 77% gleaned from the FTSE 100 index over the same period.”
However, as the 11 dividend cuts of recent months have shown, the strategy is far from foolproof. Ian Mortimer, manager of the Guinness Global Equity Income fund, says: “Businesses with long dividend track records indicate how highly regarded the dividend is, and management teams will not want those track records to end. The trouble is, this can lead some companies to pay dividends for longer than is sustainable, for instance by borrowing to help fund the dividend, or sharing too large a proportion of their earnings with investors by increasing the payout ratio.”
He adds: “What a dividend track record doesn’t show investors are the fundamentals, such as balance sheet strength and return on capital. These are much stronger indicators of dividend sustainability and help investors avoid firms more likely to get into trouble.”
Mould agrees that investors need to delve further into the dividend. He suggests “stress-testing” for earnings and free cash flow cover, for the dividend as well as the balance sheet, by looking at net debt, the gearing ratio and interest cover. He also suggests keeping an eye on any pension deficit or leases that sit on the liabilities side of the balance sheet.
He says: “The reason dividend growth can be such a compelling strategy is just maths: a growing dividend will naturally drag a share price higher over time, assuming that the dividend is funded by organic cash flow rather than asset sales, debt or other sleight of hand, which are unlikely to prove sustainable long term.”
Mark Whitehead, manager of the Martin Currie Securities Trust of Scotland investment trust, cautions against relying on economically sensitive businesses to consistently deliver income. Cyclicality is a notable feature among the 11, mostly consumer-focused, dividend kings that have brought their dividend runs to an end in order to shore up their balance sheets in response to the pandemic.
He adds: “In industries that are less cyclical and have less significant regulatory pressure, we expect to see lower levels of cuts and a faster bounce back. As visibility improves, we would expect firms in these sectors to pay at a higher level through this crisis, and their dividend levels to bounce back more quickly. Safer dividends can still be found in less cyclical sectors or where companies are able to continue to generate revenues during lockdown: consumer staples, utilities and pharmaceutical stocks.”
Rather than solely focus on income, various financial planners and wealth managers stress the importance of investing with a total return mindset. Thomas Allsup, portfolio manager at James Hambro & Partners, says: “Historically, many investors tried to live off their dividends, but these days retirement income is usually best taken from a combination of dividend income and capital growth.
“Focusing on total return frees you to think more globally, and to buy great companies with low debt and strong growth. They may not pay the highest dividends, but that is because they are efficient at putting money to use growing their businesses and generating capital value.”
Income warning: dividend disruption will continue in 2021
It is not just the UK dividend market that has hit income investors in the pocket; businesses across the globe have been wielding the dividend axe. Guinness’s Ian Mortimer estimates that in the UK and Europe total dividend cuts are in the region of 30% to 40%, while in the US (mainly through reduced share buybacks), income cuts have amounted to around 20%.
Mortimer and other fund managers with an income mandate are looking ahead to 2021, which looks set to be another challenging year. Mortimer says: “Some companies have paid or cut dividends based on their 2019 profits, so 2021 will be more of a reflection of the impact coronavirus has had.”
He adds that European dividends, which are typically paid just once a year, look particularly vulnerable where companies paid dividends in the first quarter of this year. “It is currently a difficult backdrop for dividends, but next year will be tough as well. We are looking ahead to 2021 and analysing what dividend policies will look like under different scenarios. The economic performance in the second half of the year will have a big bearing.”
The dividend kings: rule by numbers
|Share price performance
annual growth rate (%)
|11||Legal & General||120.9||198.4||16.4|
|13||British American Tobacco||50.1||102.3||7.8|
Notes: *Based on analysts’ consensus forecast for the dividend for the year to March 2020 of 67.5p a share. Source: Refinitiv data. Covers 10-year period to Friday 22 May 2020