For UK income investors, last year might seem to have been nothing short of a calamity. The dividend pool for FTSE 100 companies was pared back by a dramatic 40% as management teams sought to shore up balance sheets or to share the wider economic burden of the health crisis. For some critics of income investing, this might seem the final nail in the coffin of an ailing investment area. For investors, the year has produced an extraordinary dividend reset, with yield and growth prospects now more sustainable than they have been for years.
A good way to view this opportunity is to look back at some of the key lessons of 2020. The first of these is that the quality and quantity of a company’s return matters just as much as the quantum of profits, if not more. About half of the dividend cuts made last year are likely to be permanent as they were made by inherently low return-on-equity businesses from sectors such as banks, oil producers, telecoms, utilities and real estate with pre-existing industry specific problems and therefore dividend pressures.
The remaining half of those cuts, which were either precautionary or were made on political grounds, are likely to return relatively swiftly. Indeed, several companies started to reinstate dividends last year (BAE Systems and Direct Line Group, for example), and we have seen a regular drumbeat of dividends being restored in the latest round of earnings results. The lesson here is that sustainable dividends are more likely to come from companies with decent return structures and high levels of capital discipline.
The second lesson is that investors should be willing to look beyond the conventional notion of what
constitutes an income stock. The UK stock market, in particular, is a rich hunting ground offering a range of interesting components with which to build an income portfolio. This market is home to high quality international companies — such as Unilever and RELX — with long-term steady growth potential and high returns. Because they are listed in the UK, a market beset by Brexit headwinds in recent years, they trade at more attractive valuations than their international peer group — a discount that is no longer warranted now that a deal has been agreed between the UK and EU.
Notwithstanding last year’s challenges, cyclical companies can also have a place in a diversified income portfolio, although investors should have a clear focus on the potential for return on capital and whether businesses have a strong enough balance sheet to weather difficult times. Housebuilders, with real assets that can provide a hedge against inflation, and mining companies with top quartile cost curve assets and where there is a clear supply curve, are interesting examples of the sorts of cyclical companies we have pursued during the crisis. A more volatile high return can be a valuable addition to an investor with a long-term horizon compared to a meagre return with low volatility.
The third lesson is that investors need to be thorough in their analysis of the core drivers of returns — not just over the coming quarter, but over several years. Backed by fiscal and monetary stimulus on a scale unseen outside of wartime, and coming off a low base, there is certainly reason to be optimistic about the economic growth outlook once Covid-19 infection rates dissipate and restrictions on movement ease. However, long-term structural pressures persist in the form of ageing populations, the deflationary effects of technological change and the problems associated with eye-watering levels of debt that governments will continue to amass well beyond the crisis.
Over time, attractive real investment returns are therefore going to be tougher for companies to achieve. For that reason, throughout the crisis we have been particularly interested in businesses able to take self-help measures and that have cost advantages and the ability to grow market share — essentially, businesses that are set to make the most of the post-Covid-19 world.
A crucial point to bear in mind is that valuation does matter. You don’t need to be a value investor to make this point. A decade of zero interest rates has effectively dissolved a key anchor for investment returns. A risk-free rate of effectively zero, and a bond market backed by quantitative easing, has allowed stock-price multiples to expand largely unchecked for over a decade on excitement about the aggressive growth strategies of some businesses. If economic growth does indeed accelerate on the back of fiscal and monetary largesse, the next market regime might not be quite as favourable for companies whose business models and/or share prices are reliant on low inflation and low interest rates.
In contrast, the dividend backdrop in the UK now means there is a strong anchor for investment returns, especially with dividend yields at a more sustainable base from which to grow over time. Compared with other asset classes (for example fixed income) this is a rare characteristic that provides a valuable tool for an investor’s portfolio.
Looking more broadly at the debate around the merits of income investing, we believe that the market’s focus on capital growth at the expense of dividends reflects a pretty narrow view. Similar to the culture of share buybacks in the US, dividends can be an important part of total shareholder returns and, importantly, help instil discipline in management teams to allocate capital sensibly and to prioritise how they reinvest in a business.
The return of capital to investors through dividends has a further benefit for the wider economic ecosystem, encouraging shareholders to reinvest dividends in businesses offering higher rates of return. Many growth companies over the past few years have been partly funded by dividends from mature companies.
Last year was certainly tough for UK income investors. However, the outlook for 2021 and beyond is much improved. The year proved to be an excellent opportunity to invest in high-quality businesses with long duration assets and self-help measures at attractive valuations. Importantly, the events of last year provided a universal justification for all companies to rebase payments to a sustainable level that should be able to grow ahead of inflation over time. This is a compelling prospect in an investment world currently bereft of income.
Mark Wharrier is responsible for lead managing Majedie’s UK Income fund and for co-managing the UK Focus fund.