It has been a dismal year for income investors. The economic shock from COVID-19 has proved deadly for dividends, with scores of companies reducing, deferring or cancelling their payouts to investors altogether.
When income stalwart Royal Dutch Shell Plc. cut its dividend for the first time since the Second World War, some said it heralded the death of equity income as we know it.
Others were less pessimistic, hoping the income drought could be temporary. Last week, property company Land Securities became the first FTSE 100 firm to say it intended to restart dividend payments later this year.
However, the economic impact of the virus is likely to weigh on the level of payouts for some time to come. Historic yields for global equities are now roughly in line or slightly below long-term averages. While we can expect a recovery in dividends as economies ‘normalise,’ we don’t know how long this might take, or indeed, what ‘normal’ might look like.
So how can income investors recalibrate their strategy?
I would suggest you look to Warren Buffett. Admittedly, he has not had a good crisis, with big bets on airlines and oil companies unwinding in the pandemic — but I’m not talking about that.
The Sage of Omaha is unequivocal that the best way to return value to shareholders is by reinvesting profits back into a business.
Although Berkshire Hathaway has proved itself to be a cash generating machine over the years, it has almost never paid a dividend. The one exception was back in 1967 and Buffett often jokes that he must have been in the bathroom when the decision was made.
Now is the time for income seekers to revisit the investment basics he has famously favoured — invest in quality businesses with good management and trust them to plough the profits they make back into the business and thus drive long-term capital growth.
Recent events demonstrate a point that is consistently made, but often ignored at investors’ own peril: the highest yielding stocks do not always produce the best long-term outcomes for income investors.
Carl Stick, manager of the Rathbone Income Fund, calls it “an honest reckoning of the ill-discipline that accompanied cash returns to shareholders for many years”. Ergo, cheap funding enabled many businesses to over-distribute cash, while avoiding adequate discussion about the investment needed to lay the foundation for future growth.
It is notable that companies with higher levels of debt on their balance sheets have been at greatest risk of cutting dividends, while those with more defensive business models and stronger balance sheets have been less likely.
The other glaring risk for investors, which I have pointed out many times over the years, is that of concentration risk. This has long been a problem for the FTSE 100, where the bulk of dividend income is generated by a small and shrinking pool of companies.
Many companies had been blindly anchored to maintaining payouts, regardless of other priorities and, in some cases, common sense.
The crisis means that companies have had to reset their overall investment priorities, not just their dividend policies, as they strive to rebuild businesses that will prosper in the post-COVID economy.
They’re not the only ones having to adjust; so too are fund managers at the helm of equity income vehicles, as well as individual investors who have relied on generous, but often unrealistic, dividend payouts. So what should you consider as you re-evaluate your portfolio?
Firstly, recalibrate your income expectations to more sustainable levels as we adjust to the new reality. The profits earned by companies will be lower, and dividends will therefore be lower.
Many companies had been blindly anchored to maintaining payouts, regardless of other priorities
Secondly, be more like Buffett. The dividend yield may have been a big factor when you picked the companies in your portfolio, but now is the time to go back to basics and look at the growth strategy. Buffett believes when you buy into a business, you buy into that business model and the management. If you believe that management are good at allocating capital and the business model is solid, then stay invested.
Thirdly, be realistic. A drop in income hurts, and if you don’t have cash reserves to fall back on then you may need to sell part of your capital. But if that capital has grown because the business has reinvested it prudently, then the net result will be the same.
Fourthly, be mindful of eggs and baskets. Despite the challenging headwinds, there are still some businesses that are operating profitably and paying dividends — but you may need to look further afield to find them.
Some income fund managers have been diversifying geographically, targeting dividend-paying companies in Asia. European and UK businesses tend to pay out a larger proportion of earnings than in other markets, and so dividends have been more vulnerable. Other fund managers believe the best capital growth opportunities will come from companies that have suspended dividends, as share prices could recover strongly when payouts resume.
By focusing on the long-term growth potential, you should end up holding businesses that will be best placed to start paying a dividend when the storm passes.
Maike Currie is an investment director at Fidelity International.
© 2020 The Financial Times Ltd