Despite markets riding the liquidity wave provided by central banks, the corporate outlook remains uncertain and the crisis is not yet over. The extent of dividend cuts reflects the pain and the hazy outlook. Many high-profile FTSE 350 companies have succumbed. Further cuts are likely. In response, income investors need to achieve even greater diversification beyond the traditional UK Equity Income, Global and Global Equity Income sectors if they are to sustain dividend levels. The good news is that investment trusts, both by courtesy of their structure and exposure to other assets, are ideally positioned to assist – but pitfalls abound.
Covid-19 is wreaking havoc across the corporate landscape. BT (BT.A), Royal Dutch Shell (RDSA) and Lloyds Banking (LLOY) are just some of the dividend casualties. Previous columns have pointed to the UK’s low dividend cover (the extent to which company earnings exceed their dividend payments). Estimates suggest this fell to 1.6 times in 2019 – the global average was 2.2 times, this being a 10-year low. Further estimates suggest around a quarter of companies are paying uncovered dividends. Many have taken on debt to meet their payments – itself not necessarily helpful in the current environment.
Recent dividend cuts highlight the extent of the problem. Since the beginning of the coronavirus crisis, companies have reduced, suspended or cancelled over 40 per cent of what they were expected to pay this year. Some predictions suggest this figure could yet exceed 50 per cent. The situation overseas is not that much better, with some forecasts suggesting average dividend declines of around 35 per cent, although this varies from region to region.
Meanwhile, the market appears to be expecting dividends to rebound reasonably quickly, but this may be too optimistic. The dividend-futures market makes prices as to the total value of dividends expected and paid by the constituents of a particular index. UK contracts have recently been implying further falls of 10 per cent for dividends paid in 2021, while the longest contracts suggest it will not be until the mid-2020s when previous payment highs are expected to be achieved.
The human dimension of this crisis is profound. Many families are mourning the loss of loved ones. Many people have lost their jobs or been furloughed, suppliers have seen orders slashed, and many larger company units and smaller businesses have been permanently closed or wound-up. While people have been stoical, the cost has been high and companies need to show compassion. In doing so, and in rebuilding their businesses, many dividend payments will be a luxury they can ill afford – not just now, but in the immediate years ahead.
A good example in our sector is that of Standard Life Property Income (SLI), which has recently highlighted the balance required between working with tenants through the crisis and the level of dividend payments. Business and political leaders have not always been good at ensuring the acceptable face of capitalism prevails, but now it is more important than ever. The One Nation agenda must be robustly pursued.
The good news for investors is that most investment trusts (unlike unit trusts) can store some of their income received each year from the underlying assets, which can then help to ensure consistency in dividend payments in future years when markets are turbulent. This store of value is called the ‘revenue reserve’. It has helped the UK equity income sector produce an outstanding long-term record of increasing dividends. Immediately following the 2008 financial crisis, and despite falls in income, the vast majority of companies increased their dividends – the one exception cutting its payment by 7 per cent.
The Association of Investment Companies (AIC), the industry’s respected trade body, highlights the many ‘dividend heroes’. City of London (CTY), Bankers Investment Trust (BNKR), Allianz Trust (ATST) and Caledonia Investments (CLDN) can all point to proud records of having increased their dividends for more than 50 years. Many other trusts are not far behind and new dividend heroes are emerging all the time. The boards of these companies are keenly aware of their history and therefore protective of the record.
The UK equity income sector hosts many of these dividend heroes. Finsbury Income & Growth Trust (FGT), the Merchants Trust (MRCH) and Shires Income (SHRS) are among those held by the portfolios. The Dividend portfolio, managed on my company’s website, also holds Henderson High Income (HHI) and Perpetual Income & Growth (PLI) – such holdings help the portfolio achieve a yield of 5.5 per cent.
Most of these companies possess decent revenue reserves of between eight and 12 months’ worth of dividends, if not more. Some are further diversifying their income sources. And a few are considering greater flexibility in approach. As such, investors should be alert to those companies with lower reserves, particularly those that have taken on significant debt in part to supplement dividend payouts.
While companies held by the portfolios have been selected in part because of the extent of their revenue reserves, such reserves alone are not enough. Company boards need to be prepared to use them, as necessary – if not now, then when? This is particularly so given investment trusts enjoy the flexibility of being able to pay dividends out of capital. Those companies that do not disappoint will be rewarded by the market, and remembered by private investors in particular.
The extent of the UK’s dividend cover has usually been low relative to other markets. The level of cover of 1.6 times mentioned earlier was the third lowest globally. The portfolios have always therefore looked overseas for sustainable income. A happy hunting ground has been emerging markets, and the Far East in particular, and this looks set to continue. Companies held include Utilico Emerging Markets (UEM), JPMorgan Emerging Markets Income (JEMI), CC Japan Income & Growth (CCJI) and Henderson Far East Income (HFEL).
Interestingly, the dividend futures market for Hong Kong’s Hang Seng index has been recently forecasting a 20 per cent drop in 2020, while the 2021 contract has been suggesting a modest rise. Much of the 2020 figure accommodates the suspension by HSBC of its dividend courtesy of pressure from UK regulators. Regular readers will be aware of this column’s scepticism regarding forecasts, but the region’s many family-owned businesses, younger population (except Japan), exciting companies and growing appreciation of shareholders, all bode well for the future.
Elsewhere, it is not such a happy picture for income investors. The US market tends not to yield much – share buybacks having been preferred, perhaps influenced by remuneration packages. Europe tends to yield a little more, but has less reverence for shareholders – one senses the equity culture is tolerated rather than embraced. The futures market for both is predicting falls in dividends paid for this year and next, with Europe faring the worse.
Given the overall outlook based solely on geographical exposure, income investors will need to further embrace a ‘thematic’ approach. The portfolios were early supporters of both the sector’s relatively new entrants – infrastructure and renewable energy. Infrastructure assets in particular possess defensive characteristics, while providing sustainable and growing dividends that are underpinned by stable and predictable cash flows. Portfolio holdings include HICL Infrastructure Company (HICL) and International Public Partnerships (INPP).
Much the same can be said about renewable energy. As with any asset, issues need monitoring. In this case, managing the predicted energy price decline over the medium term will require focus. But good managements should prevail. Portfolio holdings include Bluefield Solar Income Fund (BSIF) and JLEN Environmental Assets Group (JLEN). The Green portfolio, another real portfolio managed on my company’s website, holds further examples including companies focused on energy storage and efficiency.
A further example is that of commodities, which on a range of valuation metrics look attractive after a decade or so of lacklustre performance. Shareholders should benefit from strong dividends and buybacks courtesy of the sector generating close to record free cash flow, at a time balance sheets are robust and companies remain focused on capital discipline. Furthermore, a re-rating of the sector looks due after a difficult decade of restructuring, particularly as concerns about China’s economic growth may be overdone. The portfolios hold BlackRock World Mining (BRWM).
The portfolios also have exposure to bonds, mostly corporate, and commercial property. Last month’s column (‘Reappraising diversification’, 15 May 2020) touched on the outlook for both – a differentiating factor being their respective capacities regarding revenue reserves. Holdings include CQS New City High Yield (NCYF), Henderson Diversified Income (HDIV), Regional Reit (RGL) and SLI.
The new norm
A crisis can accelerate existing trends. Courtesy of the lockdown, society is embracing ever more readily the advantages of virtual meetings and conferencing. Similarly, after rule changes a few years ago allowing greater flexibility, there has been a steady trickle of investment trusts increasingly supplementing their dividends from capital either to ensure consistent growth from a higher baseline, or to introduce payments linked to the company’s net asset value (NAV) – annual payments representing 4 per cent of NAV being both common and reasonable.
Given the current environment and the need for greater diversification, this trend will pick up pace. And it should be welcomed, provided companies do not overpromise. Dividends linked to NAVs will invariably make for greater volatility in payouts, but are generally well received by income investors who benefit from exposure to growth themes or markets that had hitherto perhaps been avoided because of lack of yield.
Examples held by the portfolios that are employing this greater flexibility include JPMorgan Japan Smaller Companies (JPS), BB Healthcare Trust (BBH), International Biotechnology Trust (IBT), Standard Life Private Equity (SLPE), Montanaro UK Smaller Companies (MTU) and Invesco Perpetual UK Smaller Companies (IPU). The introduction of such a policy, allied to good performance, has tended to benefit these companies by way of narrower discounts and a more loyal private shareholder base. Other companies are taking note.