In June 2019, Henderson International Income Trust’s head of global equity income, Ben Lofthouse, made headlines with his observation that investors lured by high yields were at risk of falling into a value or dividend ‘trap’ where yields are out of kilter with those of similar companies. He was widely quoted as saying that if you were caught in one of these traps, “you may find the income you hoped for is cut and has no prospect of sustainable growth”.
High yield traps in the UK
AJ Bell’s Q4 2019 prediction that dividends from FTSE 100 companies will reach a record high of just over £91bn in 2020 might suggest that investors depending on dividends for income have little to worry about in the UK.
“However,” the report says, “this represents growth of just 1.8% from 2019’s expected payout of £89.5bn, the lowest rate of advance since 2009 and 2010.”
Russ Mould, Chartered MCSI, investment director at AJ Bell, says that dividend growth has generally outstripped earnings growth across the FTSE 100 over the past decade. “Between 2010 and 2019, [AJ Bell] analysts’ consensus forecasts suggest that aggregate FTSE 100 net income rose by £15bn, while dividend payments rose by £43.6bn. Some of that will reflect the return of confidence as companies emerged from the financial crisis. But earnings were forecast to cover dividends by just 1.62 times in 2019, below the two times threshold that provides a safety net and some comfort that distributions can be made even in the event of unexpected bad news.”
Sustainability of dividends on a global scale
Speaking from an international perspective, Leslie Alba, Morningstar Investment Management Europe’s senior investment analyst in equity capital markets and asset allocation, says, “All else being equal, strong earnings growth makes dividend growth more durable, although this is partially biased by the starting point ten years ago, coming out of the global financial crisis.”
However, some analysts believe that recent dividend growth is unsustainable. Morningstar passive strategies analyst Dimitar Boyadzhiev notes that high yields could be the result of a fall in share price caused by trouble in the business and that in this scenario a high yield can often be followed by the company cutting or suspending payouts in the future. An example of a company whose dividend has fluctuated significantly over the past decade is Vodafone – in May 2019, it cut its dividend rate by 40%.
"Many companies have raised their dividends to levels that are unrealistic when an economic slowdown or a change in the financial backdrop arrives"
Companies may also reduce dividend payouts to finance growth opportunities, repay debt or pile up cash in anticipation of lower growth conditions. For example, Royal Dutch Shell introduced a scrip dividend after the oil price crash in 2014 in order to reduce cash outflows, and only restored it to cash in November 2017.
The key is to identify companies with a trend of stable and gently increasing dividend payouts, says Dimitar, as this is typically a sign of resilience that rewards investors over the long term.
Nick Clay, portfolio manager of the BNY Mellon Global Income Fund, says it is important to look at a company’s cash flow rather than its earnings per share when trying to determine if yields are realistic. “Many companies have raised their dividends to levels that are unrealistic when an economic slowdown or a change in the financial backdrop arrives,” he adds. “Consequently, many of these companies will be forced to cut their dividends in the future.”
Sustainability of dividends relies upon sustainable cash flow, and given the distortions of a decade of quantitative easing, a change in the backdrop that brings about problems for weak companies could be positive for the strong ones, suggests Nick. “A capital cycle is beneficial for strong companies and that is what investors need to focus on,” he adds.
The November 2019 edition of the Janus Henderson Global Dividend Index reports that global dividend growth in Q3 2019 slowed from 4.4% to 2.8% year-on-year. But Jane Shoemake, investment director on the Global Equity Income team at Janus Henderson Investors, says that payout ratios (the percentage of earnings paid out as dividends) are broadly in line with historic averages.
“We therefore believe that the current level of dividend payments can at least be maintained and even grow slightly in 2020, in the absence of a global recession,” she continues. Agreeing with Ben Lofthouse’s assertion, she says: “However, there are always some companies/sectors where yields look unrealistically high. For example, mining companies globally had increased dividends by 9%, an average yield of 3.7% before commodity prices collapsed. Stocks that have underperformed and are now generating higher yields need to be assessed to ensure that they are not value traps.”
"Investors may feel there is less risk of management doing something foolish, like making a large, expensive acquisition if any so-called excess cash is being returned to them"In the UK, Michael Kempe, COO of Link Asset Services (publisher of the UK Dividend Monitor, which tracks dividends paid by UK companies each reporting season) believes investors should be examining high yield payouts. “It is true that some companies in the UK are yielding unrealistic levels,” he says. “But the concentration of value traps in the UK is in line with the international average and we think most companies’ yields are secure.”
Shareholders are happy, for now at least, for companies to run ‘efficient’ balance sheets that hold relatively little cash, as the returns on cash are so low, says Russ. “In addition, investors may feel there is less risk of management doing something foolish, like making a large, expensive acquisition if any so-called excess cash is being returned to them,” he says.
What happens next globally?
Low interest rates globally provide an opportunity for cheaper capital restructuring, which has helped payouts through share buyback programmes. Leslie says that over the past decade, buyback levels have been robust in the IT, consumer discretionary, consumer staples and healthcare sectors and weaker in energy, materials and industrials where earnings were impacted by the commodities crash.
Payouts remain elevated in the international energy sector due to continued stress on earnings, she says. “Cost-cutting has allowed many of these companies to remain profitable at low oil prices, making the sector an interesting dividend play even if earnings are volatile and potentially vulnerable to another oil price crash.”
“They may appeal to long-term portfolio builders as well, even in the knowledge that the long bull run means some strategists feel we are overdue a degree of volatility and a correction of some kind"
State Street Global Advisors investment strategist Ryan Reardon agrees that companies are more likely to use stock buyback programmes to return capital to investors when seeking to take advantage of tactical opportunities presented by interest rates. “The impact on dividend payouts from cheaper debt is more likely driven by a company’s ability to finance opportunities that will increase its long-term earnings outlook,” he says.
The Janus Henderson Global Dividend Index reports that emerging market dividends rose by 6.2% year-on-year in Q3 2019, although almost half of the Chinese companies listed in the index reduced its payouts, and overall dividends in Russia and India were down.
According to Russ, Asian equities offer a deeper pool of dividend payers than many investors expect. “They may appeal to long-term portfolio builders as well, even in the knowledge that the long bull run means some strategists feel we are overdue a degree of volatility and a correction of some kind,” he says. While not linked to market cycles, the recent Covid-19 outbreak has led to a fall in Asian equities since the start of the year. For example, Sands China (a leading player in the leisure and gambling markets of Macau) represents an opportunity for income-seekers to pick up the stock on a dividend yield of 5.4%.
As for where clients who rely on dividend yield for their income should look if dividends were to fall dramatically, Morningstar does not view fixed income as a viable alternative for income growth because the yield is tied to prevailing interest rates.
“While rates should eventually revert higher, it is likely to be a slow process,” says Leslie. “Therefore, equities are going to provide the best income growth over at least the medium term. With respect to high-yield debt, although these securities offer strong income, the spreads are unattractive.”
Michael offers reassurance. “Dividends only fell 15% peak to trough since the financial crisis and have far surpassed pre-crisis levels now. There is simply no other machine capable of producing such consistent and attractive income among the main asset classes as equities,” he concludes.
The Janus Henderson Global Dividend Index notes that dividend investors have benefited from taking a global approach to income investing. Investors concerned about the medium-term prospects for dividend income growth would do well to similarly diversify their investments.
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