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Are L&G and M&G’s double-digit yields safe?

Current yields imply market doubts about distributions for the two FTSE 100 members
November 2, 2020
  • Consensus dividend forecasts have plateaued since half-year results
  • High yields point to intense market pessimism rather than signs of impending cuts

As a rule of thumb, double-digit dividend yields tend to imply that a cut is on the way. If a company’s market valuation is less than 10 times the amount of cash it handed out to shareholders over the past year, it’s normally a signal that investors believe capital preservation should now be prioritised over capital distribution.

This year, the severe dislocation in share prices and income expectations has left a handful of anomalies. Within the FTSE 100, Legal & General (LGEN) and M&G (MNG) stand out for their recent commitments to maintain – and even increase – payouts at levels which would normally appear unsustainable. Having both sold off by more than a third this year, the asset manager-cum-life insurers sit on forecast dividend yields of 9.6 and 12.3 per cent for this year, respectively. Next year, analysts expect dividends to hit increase further, to 18.8p and 18.3p per share. Against their current share prices, that would put L&G on a yield of 10.2 per cent and M&G on 12.5 per cent, levels normally associated with ex-growth sectors like tobacco.

Indeed, financial data provider FactSet suggests cigarette manufacturer Imperial Brands (IMB) is one of only three fellow members of the blue-chip index – along with Russian steel outfit Evraz (EVR) and asset manager Standard Life Aberdeen (SLA) – with higher expected shareholder pay-outs this year.

As markets enter a profoundly uncertain period for asset prices, inflation and interest rates, existing and prospective investors will be asking themselves whether these yields could yet prove a mirage.

The first point to note is that while dividend cuts are always hard to predict, analysts have largely halted their downward revisions to forecast distributions in the summer. As the chart below shows, the 2020 and 2021 dividend estimates for M&G have stayed level since June, while forecasts for L&G’s pay-out have plateaued since half-year results at the start of August.

Depending on your perspective, those numbers offered reassurance or disappointment. Despite posting a mere 2 per cent drop in operating income for the period, some may have taken the maintenance of the interim distribution at 4.93p as a sign that dividends have fallen down management’s list of priorities. At the same time, the group re-committed to its progressive dividend policy, with further clarification expected when Legal & General hosts its capital markets day on 12 November.

M&G is yet to demure from its policy of stable or progressive dividends, either. Powered by strong and stable cash flows from its closed-book life insurance arm, the Prudential (PRU) spin-out used its half-year results to reiterate expectations that £2.2bn of capital will be generated by 2022. Management again emphasised the sustainability of its dividend, though the subsequent share price slide suggests the market remains incredulous.

“There is a clear interest in understanding more fully the inherent credit risk, growth potential and Brexit impact in these names,” wrote Berenberg analysts earlier this month, summarising an informal poll of investors.

A separate piece of research by the brokerage offers another reason for doubt. With inflation in both Europe and the US likely to remain subdued over the next two to three years, interest rates will also remain low – or even turn negative. Berenberg thinks this is likely to suppress sentiment towards life insurance companies, which generally benefit from higher inflation, as this tends to stoke rises in interest rates and which in turn reduces the discounted value of liabilities.

Although this remains a threat, the breadth of both business models – whose asset management arms are set up to benefit from rising markets and inflows over the long run – offer decent hedges to the macroeconomic and monetary policy environment.

Neither do the companies’ earnings profiles point to imminent dividend cuts. Even after this year’s steep falls in markets, M&G is expected to generate profits of 24.9p per share, so net income should easily cover the expected pay-out without denting the balance sheet. In fact, analysts expect the group’s book value per share to nudge up to 205p by December, which would amount to a 41 per cent premium to the current price of 145p.

Though its shares trade at a premium to net assets, L&G’s shareholder equity is also expected to grow in 2020 – as it has done every year for more than a decade. Forecast earnings of 28p per share this year (rising to 28.8p in 2021) imply even greater headroom on the dividend.

In both cases, solvency ratios are well ahead of regulatory minima, which help to explain why management teams felt comfortable to overlook regulators’ coded warnings on distributions earlier this year. Regardless, equity growth is rarely a feature of companies facing liquidity crises. Income seekers should take note.

Last IC View: Buy, 218p, 5 Aug 2020 (L&G); Buy, 177p, 12 Aug 2020 (M&G)