Equity IncomeNov 5 2020

Prudent dividend cutters are best bets for equity income

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Prudent dividend cutters are best bets for equity income
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The first half of 2020 has been brutal for equity income investors, who have suffered sharp share price falls and widespread dividend cuts in the wake of the Covid-19 crisis.

The scale of these cuts, suspensions and cancellations has been huge, and it will continue to be a challenging environment for income investors for the rest of the year and into 2021.

But this does not mean investors looking for income should disregard the stock market. Indeed, the overall picture is much more mixed, despite the ongoing sense of gloom. 

While an estimated 176 UK-listed companies have cancelled payments and a further 30 have cut their dividends, some companies have increased their dividends and others have recently reversed decisions to suspend or cancel their payments.

More than ever, investors should be selective about in which companies they invest for income.

Now the dust is beginning to settle, investors need to be more circumspect, block out some of the background noise that can cloud their judgement, and search for investment opportunities with fresh eyes.  

Key points

  • Equity income has been tough for UK investors this year.
  • Many companies have been punished for acting prudently.
  • There are stocks developing innovative dividend policies.

Somewhat counterintuitively, some of the most attractive stocks, with the best long-term prospects, can be found among the global leading businesses that cut dividends in the second quarter of this year.

Under normal circumstances, a dividend cut is a signal that a company is uncompetitive in its end market, is cash-poor and has weak long-term prospects.

However, we are living in extraordinary times, and many companies have been punished for simply acting in a prudent manner, especially given the seismic and sudden impact of the crisis.

Maintaining operations

Some otherwise sound businesses cut dividends so they could shore up balance sheets and maintain investment in their operations. Such companies can be found in a range of industries, from media to consumer skincare and machinery.

Standout examples from each of these sectors include Disney, Estée Lauder and Rational – three very different companies that have been directly affected by Covid-19 and the subsequent changes to behaviours within society. 

All three cut their dividends, and their share prices took a hit as a consequence. Nonetheless, all three have the potential to provide strong returns over the long term, in our view, and the sell-off in their stocks presents an opportunity to buy into this potential at a lower price.   

Reeling from the closure of its theme parks in March, Disney cut its dividend in May, scrapping its semi-annual dividend. In line with a deteriorating outlook, the Disney stock price returned to levels not seen since 2014.

However, the future economic prospects for the company are not its theme parks, but its direct-to-consumer operations like Disney+, Hulu and ESPN+.

With Disney+ hitting 60m subscribers within the first year (compared with Netflix who took eight years to reach this number), the company is succeeding in its attempt to diversify away from its more traditional lines of income.

Not to mention that Disney has a fortress balance sheet with $27bn (£20.8bn) of cash on hand, and therefore, we expect the company to return to dividend growth next year and provide investors with a steady stream of income for years to come.

Another example of a business haven taken a Covid-19 hit is Estée Lauder, which experienced weakened demand in early January from its key growth market in China.  

Although this company has prioritised its digital strategy for over a decade, it was forced to close its bricks and mortar stores and therefore could not completely dampen the effect lockdown had on consumer demand.  

Estée Lauder reacted quickly and cancelled its dividend in April, but we anticipate this to be short term given the company’s strong balance sheet and ability to drive profitability from its e-commerce distribution channel.

While the lipstick effect is out in this downturn, skincare products like face packs, serums and moisture products are in, so this dividend cut should be short lived.  

Lastly, Rational took a different route by cutting its annual dividend by 40 per cent to reflect a drop in profitability rather than a cancellation.

Rational is the industry leader in combi-ovens for professional kitchens, with a dominant market position and a payback period of only nine months on its products for new customers looking to automate their kitchens.

This owner-operator company has a more progressive dividend policy, which is to distribute 70 per cent of earnings. This is a more effective mechanism for returning capital to shareholders because it does not anchor management teams to historical pay-outs but, instead, returns excess capital to shareholders after investing in the business.

Rational is entering a more difficult operating period than most, but we believe the demand for hot food will return to previous levels (it is just that the distribution channel may change) and therefore the dividend cut will be short term in nature.

Off the beaten track

As we enter the next phase of the economic cycle, the most likely beneficiaries of this market environment are becoming expensive, but for income investors there is plenty of value to be found in non-traditional places.

It is important to focus on total return in order to unearth companies that may not pay a dividend this year and have been unfairly marked down as a result. 

Now more than ever it is important to remain fixed on the long term, ride out the dividend hits of 2020 and have confidence in quality, global-leading companies with the potential to return their dividend next year and maintain consistent dividend growth into the future.

Storm Uru is manager of the Liontrust Global Dividend fund