The new stress testing

Today, equity investors need to begin in earnest another sort of stress testing; this time to see if their companies have the resilience to pay the dividends they had come to take for granted. And the test won’t just apply to 2020 – when payments will be shot to pieces – but to 2021 and beyond. This is because the most startling and scary effect of the Covid-19 shutdown – at least from the perspective of equity investors – is the way dividend payments have vanished.

Financial theory tells us this should not happen. Sure, from company to company dividend payments will be volatile. That’s because equity investors put the riskiest capital into a business and only have a claim on residual profits, which are always variable given the fixed and sticky costs that lumber businesses. But for dividends to disappear en masse isn’t in the textbooks.

This, however, is what’s happening. Investor services provider Link Group says that, of roughly £100bn of quoted-company dividends expected in 2020, a quarter has already been axed. At worst, it reckons dividend payouts could be halved and most likely will be about a third less than what was pencilled in.

That ‘can’t happen’ is happening owes much to circumstances. Obviously, if the government says ‘sorry, you can’t trade’, the effect of zero revenue quickly becomes profound.

Yet other factors are at work. Fashion is one. Companies are falling over themselves to axe dividends because others are doing so. Virtue signalling is another. Company bosses feel they must show that their companies share their customers’ pain. Cutting the dividend is a more credible way of doing so than applauding from the balcony of the executive suite at an appointed hour. Besides, not to cut the dividend risks relegating quoted companies to that circle of hell currently reserved for Premiership footballers.

Something longer lasting may be happening, too. That so many companies have had to axe dividends so quickly implies that much of the corporate sector has been running on empty; that it has been giving shareholders too much for too long. That may change.

The old conventional wisdom said a company should pay a dividend twice covered by earnings. To pay more – other than occasionally – was risky enough to damage a company’s share rating and therefore self-defeating. That notion was discarded as fuddy-duddy by capital-market-theory dudes who spoke of ‘efficient balance sheets’, which basically meant loading up with lots of debt and distributing as much as possible to shareholders.

Sure, I oversimplify, but the cult of maximising shareholders’ returns, which also served the interest of bosses to extract rents, has meant a progressive narrowing of dividend cover. So much so that, as Covid-19 struck, the average dividend cover of the FTSE All-Share index was down to 1.4 times.

Many of us saw this trend and accepted it. Now we need to ask rigorously, how much dividend can a company really afford?

The table below gives us an idea. It takes four holdings from the Bearbull Income portfolio and compares what they most recently paid in dividends with what they should have paid if they were distributing at a sustainable rate; ‘sustainable’ defined as two times dividend cover on the weighted average free cash flow for the past five years (weightings diminishing with time).

True, that’s a demanding metric, especially as, for most companies, free cash flow is less than net profits, the accounting measure that’s normally the numerator in dividend cover. But that’s the point – apart from the fact that dividends are paid in cash and not in accounting profits, income-orientated investors want to know which companies are least likely to let them down when the going gets tough and which are already paying out more than they should.

Take GlaxoSmithKline (GSK), which paid an 80p dividend in 2019 at a cost of £3.9bn (see table). With Glaxo’s share price at £15.10, that produced a 5.3 per cent dividend yield. Yet Glaxo only generated £5.5bn of free cash, meaning the dividend cover was only 1.4 times on the sustainable measure. To meet dividend cover of two times, Glaxo should have distributed only £2.8bn, or 51p per share, bringing a lower – but safer – yield of 3.4 per cent.

Sure, on this test most companies will be seen to be overdistributing. It will be a question of degree and, by stress-testing dividends, investors will know which ones to shun.