The outlook for income investing is more challenging now than in any period most professional investors will have experienced in their entire career.
The prospect of a sharp, global recession, and uncertainty over the duration of the current lockdown measures has led the boards of most companies in the UK to the decision to stop paying dividends.
In many cases, cyclical companies faced with huge earnings uncertainty and balance sheets unprepared for this level of earnings shock, have been forced to cut dividends and are trading on valuations reflecting the increased likelihood of rights issues.
For these types of companies, we believe historic dividends will become a permanent casualty of Covid-19 and these will be the last companies to return to paying dividends.
However, there are a large number of well-capitalised, cyclical businesses where boards have taken a ‘safety first’ approach and elected to cut or defer dividends until greater clarity emerges.
For many of these companies, we are reassured cyclically adjusted valuations represent a compelling opportunity, if investors are prepared to take a medium to long-term view.
Investors revert to 2008 playbook
In many cases, investors appear to have been scarred by the experience of 2008 and reverted to the same playbook of the last crisis without recognising companies have fundamentally changed in the intervening decade.
For example, we have recently added Taylor Wimpey, despite the recent decision of the board not to pay its final or planned special dividends.
The share price reaction to recent events can only be described as extraordinary.
In mid-February, the shares peaked at 236p, whereas less than two months later they troughed at 101p.
On the basis of last year’s dividend and the proposed special dividend, the implied yield on the shares was 18.4 per cent.
While the board has declined to pay this dividend, the company’s value has not disappeared and represents a good example of a business not fundamentally impaired by recent events and which will return relatively quickly back to work.
Thus, the scale of the share price move can be explained by looking at the company’s performance over the previous financial crisis, when the dividend was cut for three years and the company undertook a rights issue to shore up its balance sheet.
However, the balance sheet strength of the group is fundamentally different today than it was then.
In 2008, it had liabilities – net debt and land creditors – of £2.2bn compared to an operating profit of £435m, whereas today, the company has just reported similar liabilities on its balance sheet of just £184m and an operating profit of £850m.
Banking on improving yields
As income fund managers, it is a difficult choice to invest in a company that does not provide income to our unitholders, but we have a firm belief we will be rewarded by capital growth and a return to dividends relatively quickly. And there are many similar examples to Taylor Wimpey in today’s market.