Income investors should look beyond Britain to beat the cash squeeze
Dividend cuts by FTSE 100 companies won’t be repaired quickly – many firms were already living beyond their means. Investors should diversify abroad for sustainable high yields, says Cris Sholto Heaton.
The outlook for income investors just keeps getting worse. Last week telecoms firm BT became the latest high-yielding British stock to suspend its dividend. A fortnight ago oil major Royal Dutch Shell reduced its payout by 66%, the first time it has cut since 1945. Taking these into account, UK firms have now reduced, suspended or cancelled around £40bn in dividends since the beginning of the coronavirus crisis – amounting to more than 40% of what they were expected to pay this year.
Overall, dividends for 2020 could fall by 53% in a worst-case scenario, reckons Link Group, which looks after the shareholder register for many of the UK’s largest firms. Since those projections include £18bn in dividends paid before the coronavirus crisis peaked, the looming cash crunch for the rest of the year is even worse than these headline figures suggests – out of £82bn previously expected between April and December, just £30bn (36%) still looks entirely safe.
Whether dividends will rebound next year is uncertain. If you look at the dividend-futures market, traders appear pessimistic. Dividend futures are a derivative whose value depends on the amount of dividends that are eventually declared in a future year – so the ultimate value of the FTSE 100 December 2021 dividend futures contract will depend on the total amount of dividends declared by members of that index in the 2021 calendar year. Current prices for these contracts on Intercontinental Exchange imply that total dividends for 2020 will be down by almost 50% from last year and will then fall a further 10% or so in 2021. They will not even come close to regaining past highs by 2026, which is the last contract currently available for trading.
It’s important to note that the market value of these contracts reflect traders’ forecasts for what will happen to dividends – and we all know that forecasts are not hugely reliable. What’s more, liquidity in more distant contracts is pretty low – in fact, there is only significant amounts of trading in 2020 and 2021 contracts in most cases. Finally, because each contract doesn’t settle until after the end of the relevant year, they should trade at something of a discount to the value of the dividends the market expects – ie, longer-term contracts will trade at a much steeper discount to allow for the fact that it will be years until the buyer gets paid and for the high level of uncertainty over how much the payment will be.
These factors suggest that it doesn’t pay to put much weight on what dividend futures imply about dividends five years from now. But it’s definitely worth being aware that people who trade this market professionally are not betting on payouts snapping back in the next couple of years.
Reality catches up with big spenders
Obviously, the outcome will depend partly on the strength of the economic recovery – if we have a rapid, V-shaped rebound, dividends will come back faster. That could happen if we quickly find more effective treatments for Covid-19, or develop and scale up a vaccine sooner than expected, or find that a combination of sustainable changes to how we work and live, combined with moderate levels of immunity in the community, makes it a manageable medium-term problem. However, there is a strong argument that even if the economy rebounds rapidly, UK dividends are not going to recover in the same way.
The FTSE 100 has had an unusually high dividend yield by global standards for quite a while. That’s partly because it has a high proportion of cyclical sectors: these tend to pay large dividends in good times, but need to cut when the cycle turns and so they trade on lower valuations to reflect that. However, a growing number of firms had dividends that would be slow to grow at best and increasingly unsustainable at worse. Among the ten largest dividend payers before the crisis hit, the average dividend cover – the amount by which earnings exceeded dividends – was just 1.4. That doesn’t provide much of a cushion.
This crisis has provided the necessary excuse for management to cut their dividends and rebase them at a level that may be more sustainable for the long term without angry shareholders calling for their heads. Those firms cannot and will not rush to restore their previous payouts when the crisis passes. In fact, management have something of an incentive to resume dividends as low as possible so they make themselves look good by growing payouts over several years.
There will still be income opportunities – we look at some ideas below. However, this crisis shows why sticking to familiar UK stocks for income – as many investors still do – gives a false sense of security. Investing around the world allows you to build up a more diversified and robust portfolio.
Look east for more options
That said, right now Europe looks only modestly more promising. Dividend futures for the Stoxx 50, traded on Eurex, predict a fall of 33% this year and 8% the following year. Many European stocks also have the disadvantage that withholding taxes on dividend income are quite high – so a 3% yield on a Swiss stock is cut to under 2% when the Swiss government holds on to 35% of that. You can claim a portion of this back, but many countries make it as bureaucratic as possible and it’s not always possible with stocks held in an individual savings account (Isa) or self-invested personal pension. I hold quite a few European blue chips in my own portfolio – but this is the biggest drawback with many of them.
US dividends are forecast to be cut less – 13% per year in 2020 and 2021. US withholding tax is just 15% for UK taxpayers so long as you complete a W-8BEN form every three years (a simple process through your broker) and that falls to zero for stocks held in a Sipp. But US dividends are low – the S&P 500 has a yield of just 2%. Company managements tend to favour share buybacks instead of dividends as much as they can (see page 13). I’ve kept many high-quality US companies as long-term holdings – but this is the world’s most expensive major market and so there are very few firms that offer obvious value as an income investment right now.
The best option for diversification and growth is Asia – notably Hong Kong and Singapore, which benefit from no dividend withholding tax. I wrote about the opportunities in this part of the world in early February. Since then, shares have got cheaper, yet dividends look like they should hold up much better than the UK. Dividend futures for Hong Kong’s Hang Seng index forecast a 20% drop in 2020, but much of that is due to HSBC suspending its dividend under pressure from UK regulators. The price of the 2021 contract suggests a modest rebound next year.
There are short-term risks: many of these countries are currently leading the world in dealing with Covid-19, but we can’t be certain that will continue. Their economies cannot avoid being affected by the collapse in demand in the rest of the world. And in the medium to long term, it’s unclear what the geopolitical and economic impact of the crisis will be – we must expect the focus on supply-chain security to bring some manufacturing back to Western countries in sectors such as medicine. There are also individual risks: Hong Kong’s political crisis has been out of the headlines for obvious reasons, but as the coronavirus passes, protests will resume. It’s just a matter of how bad the situation will get.
Still, for most of the companies I profiled back then, the investment case has been little changed by the coronavirus crisis and likely dividend cuts are limited.
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