Nice little earners

Anyone running an equity portfolio for income should currently be asking one question above all others – how much income is my fund likely to produce in 2021? After the miseries of 2020 – a year when, for a while, dividends disappeared faster than seemed humanly possible – it is the unknown that looms largest.

Fifty two of the FTSE 100 index companies axed or cut their payouts in 2020 and those contributed to 354 of the All-Share index’s 613 constituents doing likewise. In the process, monies distributed by London’s quoted companies fell by something over 40 per cent on the year, but at least this provides the base for a spirited rebound this year.

Quite possibly. But, for every income investor, the more pressing matter is to estimate how much of a bounce his or her portfolio is likely to see. Let’s pursue that with reference to the Bearbull Income Fund, which had its share of 2020’s parsimony, receiving just 63p of income for every £1 it had received in 2019.

Like many readers’ portfolios, the Bearbull fund is not the same as the one that started 2020. During the summer, out went five holdings where the companies concerned simply did not look capable of resuming dividends any time soon. In came five alternatives that looked capable of maintaining theirs, albeit at the price of a lower yield for the portfolio. But this means that comparing 2021’s possible dividend receipts with the £10,513 of income that the fund actually received in 2020 is not a like-for-like exercise. We can get closer by calculating what the income fund would have received in 2020 had its holdings throughout the year been the same as those held currently.

Under those circumstances, the fund would have received just under £10,000 in 2020. Yet that is not as disappointing as it sounds since the purpose of the summer’s exchange of holdings was to swap formerly high-yielding shares, where dividends were no longer in prospect, for lower-yielding holdings, where the payout looked fairly safe. Encouragingly, on the basis of City forecasts, the current components of the Bearbull fund are forecast to make payouts that will generate just over £12,000 of income in respect of 2021, an uplift of about 14 per cent on what the fund actually received in 2020.

True, this is a rough-and-ready exercise and that phrase, ‘in respect of 2021’ is important since it implies that some of the dividend payments for 2021 will fall into 2022. Equally, it is quite likely that some payouts to be announced in the next couple of months – and in respect of 2020’s second-half trading – will be higher than they would have been had they been declared just a few months ago. In which case, 2021’s receipts really will be usefully above 2020’s.

In addition, it is important to dig down to the granular level and get a fix on the ability of each component of a portfolio to pay decent dividends in 2021. Take foundry-consumables supplier Vesuvius (VSVS), whose much-reduced payout in 2020 contributed to the Bearbull fund’s drop in income. Come the most frightening phase of the pandemic, the bosses of Vesuvius – like many others – axed a dividend that had already been declared (in this case, the 14.3p final). That move saved the company £38m but also meant the income fund received 6 per cent less income during the year than it would have done otherwise.

Yet hindsight – always easy – shows that the payment could have been made comfortably and that offers a clue about the future. To explain, take Table 1, which shows some key figures from the primary statements of Vesuvius’s accounts, its income and cash-flow statements and its balance sheet. In this exercise, it is sensible to include as a reference point the most recent year that was completely unaffected by the pandemic.

Vesuvius’s pro-forma statements for the 12 months to end June 2020 shows how the pandemic hit trading, but also how this was more than counter-balanced by the response of the group’s bosses. In that period, Vesuvius lost almost £170m of revenue compared with 2019, or 10 per cent. This fed through to a 37 per cent drop in both pre-tax and net profit. Interestingly, however, that still generated almost 28p per share of accounting earnings, which was 1.4 times more than the dividends declared for 2018, the most recent period completely unscathed by Covid-19.

Meanwhile, cost savings and rigorous working-capital management meant that operating cash flow held up well. Most years there is an even chance that Vesuvius – like most companies – will see an outflow in working capital as its bosses seek to grow the business. However, in the 12 months to June 2020 changes in working capital brought in £74m of cash, much of that in the first half of 2020 as management ran down inventories and debtors. Couple that with a small drop in capital spending and free cash flow, the cash left over for shareholders, was exactly the same as 2019’s at £119m. Yet shareholders’ claim on that free cash shrank to £17m; this reflected the half-year dividend for 2019, which was paid in the second half of that year.

Cash-conservation measures, such as cutting the dividend, helped bolster Vesuvius’s balance sheet. With the added help of cost savings, which were on course to deliver £40m a year, the group’s net debt at the end of June was actually lower than it had been before the mayhem started – £230m compared with £246m. In the process, the ratio of net debt to equity nudged down a couple of percentage points to just below 20 per cent. On the other commonly used metric for a quick assessment of financial health, that of net debt to ‘ebitda’ (basically, gross cash profit), there was a minor deterioration between December 2019 and June 2020 as the ratio rose from 1.1 to 1.3.

All this prompts the thought – why was the dividend slashed so ruthlessly? Management may well have had similar thoughts because in October, 10 months into the financial year, they announced a half-year dividend for 2020 at the half the rate of 2019’s; still, better than nothing. A further update in November confirmed that Vesuvius was on course to finish the year in a stronger financial position than it started and trading, though well down on 2019’s level, was continuing the modest revival that began in the third quarter. In which case, a final dividend for 2020 – results are due at the end of February – is almost certain. It could be at the same level as 2019’s cancelled final (14.3p per share at a cost of £39m), although prudence is likely to mean the directors will declare something closer to half that amount.

The underlying point is that what is true of Vesuvius applies to a good many other companies. Sure, for those at the discretionary and social end of the consumer sectors – from the likes of bowling-alley operator Hollywood Bowl (BOWL) to pubs group JD Wetherspoon (JDW) – the period of enforced suspended animation drags on and on. But even some of those, such as Hollywood Bowl, will emerge in financial shape at least as good as they went in.

At least this implies that much of the corporate sector will be able to attack any economic bounce-back with gusto and that provides further confidence about the coming level of dividends. So, the answer to the question with which we started – how much income is my equity fund likely to generate in 2021? – might run along the lines ‘enough to produce a half-decent yield’ (say, 4 per cent plus). But, of course, yield also depends on the denominator, in this case, market value. At one level, market value should take care of itself given the amount of central-bank money being thrown at any economic variable that moves (and probably a good few that don’t). True, that stacks up problems for the future. Closer to the present, there remains the greater problem that the western world’s mind-set about living with Covid-19 remains hopelessly unrealistic. Discussing that, however, is for another time.

Email: bearbull@ft.com