If you’d told investors at the start of 2020 that a crisis would halve UK dividends, nobody would have believed you. Yet that’s roughly what happened in the second and third quarters of the year.
A drop on that scale has never been seen before – not in the financial crisis, not in the dotcom bust, or in any previous crisis. Not even during the Great Depression did they fall so far that fast.
Still, the damage has been a little more discriminating than the headline figures suggest. And those looking to profit from a recovery should take note.
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The defensive core of an income portfolio has proved its worth this year
The collapse in UK dividends this year has been unprecedented. But much of it was due to huge cuts in a handful of sectors that accounted for a large share of income.
Banking – where regulators made firms suspend dividends entirely to conserve capital. Oil & gas – where dividends had been held at unsustainable levels for years despite lower oil prices, and it took the collapse in demand to finally force management to reset them.
Many businesses kept on paying just as before. Consumer staples such as Reckitt Benckiser and Unilever. Pharmaceuticals such as AstraZeneca and GlaxoSmithKline. Drinks firms (Diageo) and tobacco (BAT). These are classic defensive businesses and they proved their value.
Investors should consider stocks like these as part of the core of an equity income portfolio, rather than concentrating on the highest-yielding companies. Their yields give you an idea of what might be sustainable, and can grow at a bit better than inflation over time. That could be topped up with higher-yielding firms to raise the overall income a bit, without putting everything at risk in a crisis (which is what happened to any portfolio that was built around the more tempting higher yields in financials or natural resources).
Of course, some of the firms that managed to keep dividends unchanged in 2020 managed to look good because they’d already taken a hit previously. Miner Rio Tinto cut its dividend in 2016 at the point of maximum pessimism for miners; it has avoided having to do so again (although not all its peers have done so well). Vodafone cut an unsustainable payout in 2018. That hurt the shares at the time, but it ended up looking better in this crisis than BT, which was one of the biggest cutters when it was finally compelled to do the same.
Missed dividends and missed opportunities
Not all defensives sailed through unaffected. In tobacco, Imperial Brands took the opportunity to slash a dividend that was also starting to look unsustainable. A few firms that did not look especially high risk still suspended payouts out of an abundance of caution. Most notably, defence group BAE, which was one of the first to reinstate its regular dividend and propose a special dividend to catch up on the one it had skipped.
There are also a few big payers where I’m surprised management didn’t use the cover afforded by the crisis to trim dividends and give themselves a bit more room for manoeuvre in future. The most obvious example is the utilities sector.
Yes, these companies enjoy stable demand and regulated levels of return, but dividend cover tends to be low and debt levels are often high. It’s sensible that utilities focus mostly on delivering steady cash to shareholders in the absence of opportunities to grow, but I cannot shake the view that the sector has pushed this as far as it can – both in the UK and elsewhere – and that a reset now might prove better in the long term.
Where investors remained sceptical
For the most part you’d expect firms that held dividends this year to hold them or raise them modestly next year. It’s worth noting that markets clearly still have some scepticism about the sustainability of yields at certain firms that avoided cutting.
Vodafone yields 6.5%, for example; investors remain concerned about debt levels, competition and whether its turnaround plan will deliver. BAT yields almost 8% – although Imperial Brands yields 9% even after cutting, so this is largely about the long-term outlook for the tobacco industry as a whole. Legal & General yields almost 7%, even though the insurer kept paying while rivals Aviva and RSA bowed to regulator pressure to suspend payments.
These kinds of stocks could do well if they maintain dividends – I would suspect that investors are probably assigning a higher risk of cuts in the short term than they would usually do, simply because of the trauma of the last few months. However, they are unlikely to deliver much growth.
Looking for stocks that can restore dividends
The most interesting opportunities may be in companies that are reinstating dividends or raising payouts that were heavily cut. Many will be starting from a much lower base and lower expectations. In some cases, the scale of their cuts means that income investors and funds may already have dumped them.
So the opportunity for them to surprise to the upside and to deliver both rising income and share price gains will be great. It’s wisest to think about this on a medium-term view – it seems pretty rash to predict what next year might bring economically when this crisis is by no means over.
The extent of the cuts means that there is no shortage of possibilities here, both in the FTSE 100 and beyond. BP and Shell could be examples of this, on the basis that they have rightly cut so aggressively in this crisis that they should be well placed for decent growth once oil demand recovers. Another consideration could be Rio Tinto, which has more than doubled its regular dividend since cutting 2016.
Companies such as these are plays on a global recovery, while a lot of other potential picks are geared to the UK economy. Examples would be the housebuilders, many of which are already recovering as they reinstate dividends, and the banks, where it’s not yet clear when they will be permitted to do so.
As far as I’m concerned the most interesting income plays on the UK are commercial-property real estate investment trusts such as Land Securities and British Land. Both have already declared that they will resume dividends at a lower level than before. Shares have rebounded a little but remain beaten down by fears that people will no longer work in offices and shop in malls. If you believe that this is overstated, you might consider this to be cheap.
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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