It is now estimated that cuts to dividends globally could amount to somewhere between 15 per cent and 33 per cent.
In the UK the fall could be as much as 50 per cent.
Dividends are a mechanism for returning surplus cash to shareholders.
Like other metrics such as sales growth and return on capital, their absolute level is determined by the success of the company and where it is in its lifecycle.
Shocks such as Covid-19 tend to accelerate adverse trends already in place.
The UK has been hit harder as many of its larger companies such as BP and Shell are in secular decline.
Countries such as America, Germany and Switzerland, with a greater proportion of growing and financially healthy companies, have suffered much less.
Harvesting this cash flow is a key part of the equity investment proposition.The debate
Many of the arguments that rage about the importance of income in equity investment, in my view, miss this point.
Income managers argue that long term outperformance derives from the additional return provided by reinvested dividends.
General equity managers argue income detracts from total returns as it restricts the universe to mature or declining companies.
In reality, the success of any equity investment first and foremost derives from the level of return on capital the underlying company can achieve multiplied by the amount of capital invested; termed ‘economic profit’.
Companies have a defined lifecycle involving fast growth and growing returns then higher returns with slower growth and finally falling returns.
Faster growth in economic profit, occurs in the first two phases.
In certain companies, this can extend for decades.
As the companies move through the cycle, less cash is required for investment.
In addition, better companies tend to require less capital to grow, so there is often more surplus cash generated.
Dividends are used to pay out the surplus.
Harvesting this cash flow is a key part of the equity investment proposition.
Successful businesses that achieve high returns will attract competition.
These new entrants will cause return on capital to fall back towards the cost of capital or even lower for those companies without strong competitive advantage.
Sometimes, skilled management will be able to re-engineer the business or redeploy capital into new areas with better characteristics.
Currently, there is a pressing need for many investors to convert capital sums into reliable ‘income’ streams over extended periods. Risks
However, turnarounds are difficult and high risk.
Dividend yields are often high at this stage reflecting both legacy pay-out ratios and the company’s higher cost of capital.
Some income managers make the mistake of focusing too much on these situations. On the whole, they should be left to specialist recovery managers.
While Warren Buffett has yet to pay a dividend from his Berkshire Hathaway investment vehicle, careful reading of his letters to shareholders shows that many of his successful investments, such as See’s Candy, paid substantial dividends up to the holding company.
He discussed See’s, a high quality chocolate brand popular on the US west coast, in his 2007 letter.
By that time, it had paid $1.3 billion up to the parent company, which compares to the $25 million paid to acquire the company in 1972. Buffett invests in dividend payers.
Dividend income is important.
Equity income opportunities
Currently, there is a pressing need for many investors to convert capital sums into reliable ‘income’ streams over extended periods.
In the UK for example, there is an estimated wall of money of £0.5 trillion per year of pension capital seeking long term income.
The average pension fund investor requires this to last for over 25 years.
A white paper prepared by the Chartered Financial Planners in May 2019 provides a very compelling argument as to why equity income portfolios are the best and perhaps only way of achieving this.
This is because they are capable of producing a relatively stable and growing income stream over time that preserves its purchasing power without having to dip into capital.
Dividend income and growth is generated by companies achieving high returns on capital. Strategies using small sales of capital each year as an alternative to income can suffer from the ‘sequencing’ risk of weaker general equity market performance in earlier years.
Their study focused on mainstream U.K. listed investment trusts with differing investment strategies.
Even better results can be secured by utilising Buffett derived principles.
The strength of See’s Candy derives from two important qualities.
Firstly, an enduring brand derived from the quality of the product underpins extreme longevity of the franchise.
Secondly, as referred to above, great companies such as this require limited capital to grow the business resulting in considerable surplus cash available for distribution.
Income managers can incorporate these characteristics into their investment strategies.
Such companies are not common so a relatively concentrated portfolio is assembled.
Risk is further reduced by avoiding companies that are financially leveraged.
Dividend income and growth is generated by companies achieving high returns on capital.
By combining the general benefits of an equity income strategy with specific active investment management refinements derived from Warren Buffett, savers can contemplate a reliable income for life while also growing their savings.
Michael Crawford is chief investment officer at Chawton Global Investors
