Friday HighlightMay 15 2020

The hunt for sustainable income in uncertain times

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The hunt for sustainable income in uncertain times

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.

The share price reaction to recent events can only be described as extraordinary.

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.

As income fund managers, it is a difficult choice to invest in a company that does not provide income to our unitholders.

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.

The banking sector has been forced by the regulator to suspend dividend payments and support the economy through this period.

Investors have again been scarred by the experience of 2008 and valuations have been impacted.

However, we are encouraged by the improvements in capital and liquidity in the entire banking system, as well as cautious lending behaviour.

We have significantly added to Paragon, a buy-to-let mortgage lender, in recent weeks, as we feel investor concerns reflect the performance of the group a decade ago when it was left exposed by its reliance on wholesale funding.

In recent years, Paragon has received a banking licence, removing this flaw in the business model, and had a much better positioned lending book entering this downturn than in the last.

Another financial holding we have added to significantly over the crisis has been Legal & General.

We are highly encouraged the board has chosen to pay its final dividend in the face of a regulatory recommendation for insurance company boards not to pay dividends unless they are certain policyholders are protected.

Its solvency capital remains robust and it can fully support the real economy throughout the current period.

We are encouraged the measures taken thus far are having the desired effect.

Tapping into alternative income sources

As a multi-asset fund, we also have the ability to invest into other asset classes where there are some enticing income streams still available to investors.

For example, the TwentyFour Income Fund is an investment trust with a portfolio of investments in residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and collateralised loan obligations, managed by a highly respected manager.

The fund has seen its capital value fall in recent weeks, as spreads have widened in this area, and the yield on purchase of the fund was 7.2 per cent.

The economic impact of Covid-19 will remain uncertain until the various global restrictions to curb its spread have been lifted.

We are encouraged the measures taken thus far are having the desired effect. Daily death statistics have fallen globally and countries are gradually reopening for business.

We are considering the effect on the yield for this year under two scenarios.

 In the first, we assume all companies that have already announced dividend cuts pay nothing for the entirety of the fund’s 2020-2021 financial year, as well as taking a prudent view on certain cyclical companies that have not yet given guidance on dividends.

In this scenario, the reduction in income from current levels is estimated to be 52 per cent and the estimated yield on the fund would currently stand at approximately 3.7 per cent.

In our second, more optimistic scenario, we would anticipate a number of companies returning to paying dividends later in the year but at a reduced level compared to 2019.

We would then anticipate further dividend growth into 2021. On this basis, the reduction in income from current levels is estimated to be 36 per cent and the estimated yield on the fund would be about 4.9 per cent.

Philip Matthews is co-manager of the Wise Multi-Asset Income Fund at Wise Funds