It has been a painful year for dividends in the UK market and investors relying on dividends for income. But every shock is an opportunity to reset and clear out some concerns. Harsh scrutiny has been applied to companies’ characteristics, particularly their operating and sustainable free cashflow. This should lead to a ‘fitter’ market of dividend payers.
Reacting to the shock
It seems fair to use the analogy of a meteorite landing to describe the impact of the pandemic. We’ve been able to look at the depth and width of the crater, and establish a line of sight on what things will look like on the other side. We were clear in March and April that our ambition was to come out of this with a stronger portfolio, which had better cashflow characteristics and sustainable dividends.
This involved a lot of bottom-up work in April to confirm our dividend profile. We spoke to the management teams, customers and competitors of our holdings to model our dividends for the rest of 2020. A potential reduction of 30-35% was the hypothesis. In the six months since that exercise, we’ve grown a little more confident that the outcome might not be so bad. Managements’ actions on costs and cashflow have limited impairments. Some companies have not cancelled, as we’ve seen with 3i, Daily Mail & General Trust, Direct Line and Smiths Industries. Some have re-instated their dividends and done so more quickly than we had anticipated. Today, our best forecast is a dividend of approximately 3.8% (at current market valuation) which we believe can grow at mid to single digits for the next few years.
Imposition, disaster or catastrophe?
Our approach has always been cashflow first, dividends second. If you start with dividends and work backwards, you can end up in cul de sacs. We seek to identify cashflows which are under-appreciated. This can be because of the individual stock’s valuation, an outlook for the sector which is overly-pessimistic or an under-appreciation of the sustainability of cashflows.
Especially in this environment, we have to make a judgement on what is structural and what is cyclical – and then evaluate the potential impacts on cashflow. In this year’s market, we’ve been asking ourselves: what looks like a permanent impairment and which revenues are likely to come back?
There may be permanent impairment for high street operators, for example. But we feel comfortable in saying that that Wembley Stadium will, at some not-too-distant point, be full again. Concerts will be held at the O2 Arena. These statements might seem a touch optimistic as we face a potential winter wave of the pandemic. But they’re less controversial than the opposite conclusion, which appears to be the default assumption for some at present.
A ‘cleaner’ market
More broadly, the market is fitter for purpose. At the start of the year, the total market capitalisation of the UK was £2.5trn. It was paying out just over £100bn in dividends, giving it a yield close to 4.2%. Roll forward to this month and we have a market cap of £1.9tn, with a forecasted £65bn in dividends for this year. That gives it a yield of around 3.4%.