Why investors should look past dividend cuts when seeking income

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%.

Importantly, though, 70% of those dividend cuts have come from two large sectors: oil & gas and banks. These cuts or suspensions have been for different reasons. In oil & gas, the challenges were more structural and driven by a need to change their business models and become more environmentally friendly. All of this when cashflows were taking a hit from weakened oil demand. For banks, which came into this crisis well capitalised and prepared for a difficult environment, the suspensions were driven by regulators. 

Market reset

We now have a market with an anticipated £65bn in dividends which are much more broadly spread across five or six sectors. This should mean that the dividends are based on more sustainable cashflows and that the companies will have better dividend cover and more promising prospects for growth. 

We can also expect a return of dividend payments, assuming a normalisation of the economy. We believe that will start to happen in 2021.

Keeping the discipline

That said, it’s important not to be drawn to companies which have had resilient earnings in the past. Some will face structural challenges, such as carrying significant debt, large pension liabilities or cumbersome rent rolls. Some cyclical stocks will struggle to recover. Others might have some form of competitive advantage, despite being in a cyclical industry. 

Some of the growth stocks today might be open to being disrupted in the future. It may seem inconceivable today, but we remain alive to the risks posed by, for example, the pace of change around innovation, ESG, cost of capital and technology.

One of the challenges we face when assessing technology stocks is the risk from low barriers to entry. They definitely exhibit growth, but what are the medium-term assumptions on profitability that you put into the discounted cashflow?

Looking ahead…

We look for companies that exhibit a resilient cashflow, and can support a sustainable dividend yield that can grow conservatively over time. We focus on industry characteristics, understanding the value chain that a business is in and the sustainability of its position within that. We do this on a bottom-up basis, rather than through a categorisation which is top-down; and we challenge each other continually to ensure the original investment rationale still holds. While it has been a very difficult year, we believe that there are opportunities in the markets. And we feel more confident about the quality of dividends in the market and the prospects for them to grow as we emerge from this crisis.

Nick Shenton and Andy Marsh manage the Artemis Income Fund. 

Visit the Artemis website for more information, or further investment insights.