How dividend cuts are affecting funds

Ross Brookes, Head of Charles Stanley’s Collectives Research Team, looks at the implications of dividend cuts on UK equity income trusts and open-ended funds.

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  1. Ross Brookes

The recent spate of dividend cuts and suspensions serve to highlight the ‘concentration’ risk of dividends in the UK stock market. Most notably, UK banks have suspended all dividends and share buy-backs until the end of 2020. The only sector contributing more than banks to the market yield is the oil majors which gives little comfort with crude prices near 20-year lows – albeit Royal Dutch shell hasn’t cut its dividend for a long time. Subtract the dividends of the banks and the energy stocks (which together make up 38% of the UK market yield) and the UK market yields a more modest 4% rather than the headline historic yield of 6%.

Most investors are aware of this and have diversified away from UK dividend payers into global equity income stocks and other areas. But it still means a significant drop in the income from a typical portfolio.

UK dividends tend to grow most of the time. From a base of £13bn in 1989, aggregate UK dividends have grown to £104bn in 2019. This growth has been the bedrock of the total returns that investors have enjoyed over that period. Dividends have fallen in only four years during that 30-year period – 1993, 2004, 2009 and 2010. Given that around a quarter of UK listed companies have already announced dividend cuts it is inevitable that 2020 will become the 5th year to join the list.

Why have dividend cuts been so aggressive? During the lockdown phase, many companies will suffer a partial or complete collapse in revenues, unlike previous recessions when revenues have been dented but not fallen to zero. Earnings turning negative will lead to temporary covenant breaches. Banks will be expected to provide waivers, but dividends will still need to be stopped. In the current climate, management teams will be aware of political sensitivities, especially if their business is linked to government bailouts either directly or through the furloughing of employees. Withdrawing a dividend after the ex-dividend date, previously unheard of unless in the most extreme of cases, has become a reality in the UK market. We live in extraordinary times.

What does it mean for funds and investment trusts?

Distributions from open-ended funds – such as unit trusts and OEICs – are directly linked to underlying dividend or interest earned, so when companies cut or cancel their dividends a fund’s income payments fall commensurately. However, for investment trusts, which are closed-ended, it’s different. They can usually retain surplus income and smooth dividends during market stress.

Investment trusts can save up to 15% of their income each year into reserves. In a more recent and increasingly popular phenomena, some investment trusts also pay income from capital. According to Investec, in the immediate aftermath of the financial crisis, 11 out of 14 UK investment trusts increased dividends. There was only one which cut its dividend (Finsbury Growth & Income by just 7%). At this time Aberdeen Standard Equity Income Trust’s earnings per share fell by 11% but it increased its dividend by 7%, a good example of how an investment trust can ‘smooth’ income through a crisis.

Investec has also modelled the current situation to see how trusts might withstand the significant, but in many cases temporary, falls in dividends across the UK market. It found that all the UK income trusts it modelled could endure a 30% fall in dividend income from underlying holdings over the next year, and still pay a progressive dividend (they assumed a 3% rise). The 30% figure was used because this is the dividend decline that is being priced in by the futures market.

Attention will turn to investment trust boards who will have to make a difficult decision whether to use revenue reserves or ‘rebase’ dividends to a lower level. With little or no visibility on the length of disruption for the global economy and by extension dividend payments this is a tricky balancing act. Our sense is that boards will be loath to rebase given their proud record of maintaining and even growing dividends through previous periods of market stress. Aligned to this, many shareholders specifically invest in these trusts for the security of the income.

Foundation Fundlist investments

Since mid-March, well over 100 companies have either cut or suspended their dividends in the UK market. This is a fluid situation and will likely increase in the coming weeks. During the financial crisis, the UK market pay out fell 23% from peak to trough, and it will be more severe this time if the futures market is an accurate indication. Oil & Gas accounts for 21% of dividend payments and it remains to be seen whether the heavy falls in energy markets will result in a lengthy period of lower prices and translate into dividend cuts in the future.

The equity income funds and trusts we have on the Foundation Fundlist have been affected to varying degrees. In assessing what each of our fund managers has been doing, we are searching for signs that investment processes are being followed through these most difficult of times. We don’t want our managers rejigging portfolios to try to capture as much short-term income as possible at the expense of longer-term returns.

Aberdeen Standard Equity Income

In terms of income reserves, this investment trust compares favourably to most others in the sector, holding over 10 months’ worth of the prior year’s dividend in reserve. This provides a sizeable cushion in a fallow year for UK dividends. The trust is around 10% geared (which means it borrows to invest), which has exacerbated the trusts weak near-term performance.

Whilst manager Tom Moore doesn’t have exposure to UK banks, he has been hit elsewhere as all UK Equity Income funds have to a degree. In particular, a medium-sized and smaller company bias has been unhelpful in the selloff. Moore believes it makes sense to own a selection of ‘COVID-resilient’ stocks. These stocks could re-rate as the market seeks refuge in companies whose outlook is independent of coronavirus. He includes tobacco stocks BAT and Imperial Brands in this and has been adding to both during March. He has also added to Vodafone, Rio Tinto, BAE Systems, MoneySupermarket.com and Hastings.

Another group Moore has been keen to add to are those he labels as ‘window of opportunity’ stocks where he has a strong conviction in the valuation re-rating upwards. Examples within the portfolio include Close Brothers, Chesnara, GVC and National Express. At the time of writing, six portfolio stocks had announced dividend cuts (Mitie, MJ Gleeson, Vistry, DFS, Playtech & New River REIT). Historically, the trust’s best returns have been made in the wake of risk-off periods; moments of extreme fear, such as this, can cause markets to overshoot, creating buying opportunities, though past performance is not an indication of future returns.

Evenlode Income

This fund has never been a ‘high dividend’ option given its preference for ‘asset light’ businesses and a resultant portfolio heavily skewed towards the consumer goods & services, healthcare and technology sectors, and away from capital intensive industries such as energy and mining. It is therefore been relatively resilient in the sell-off.

Manager, Hugh Yarrow, suggests trying to give an exact dividend forecast for the fund's financial year to 2020 would be something of a fool's errand, given the current situation. Several companies that have cancelled dividends in the portfolio have noted they may still announce a supplemental dividend to replace them later in the year. These companies include Bunzl, Smiths Group, Savills, WPP and Rotork.

Cancelled dividends in the fund that have already been announced account for approximately 16% of the dividend stream. Of these, perhaps a quarter may be paid later in the year depending on how conditions look, based on management comments. Over and above this, Yarrow is expecting a further 5% or so of the fund's dividend stream to be cancelled or postponed in the shape of Informa, Compass & Burberry. Given the current lockdown situation, there may also be some other companies that decide to cancel or postpone dividends over the next 2-3 months.

Many of the larger holdings, that form the bedrock of the dividend stream, are repeat-purchase businesses models in the consumer-branded goods, healthcare and digital sectors which does provides some resilience for the fund’s income stream, even during this very difficult period. The portfolio is focused on market leading businesses that Yarrow thinks will be able to endure this crisis and emerge with their competitive positions in many cases strengthened. Therefore, looking past the current lockdown phase and at the likely medium and longer-term dividend flow, he is confident that most companies in the portfolio will restore dividend policies to pre-crisis positions or similar.

JOHCM UK Equity Income

Clive Beagles and James Lowen’s UK Equity Income fund has significantly underperformed the market during the recent market volatility. Defensive stocks performed strongly and economically sensitive ‘value’ areas where the fund currently mainly invests fell materially, which has provided a major headwind to performance.

The first quarter income payment from the fund was down 19% quarter-on-quarter when compared to the same time last year. McCarthy & Stone, Vistry and Hammerson account for most of that cut (the team had expected a cut of around 5% pre coronavirus taking hold). This historically the smallest quarter for the fund, representing around 20% of the total dividend paid in 2019. The cancellation of bank dividends will significantly impact the fund’s second quarter payment, with the team looking at a temporary year-on-year cut of up to 50% across the fund’s overall income during 2020.

More positively, the managers report that the consistent message from portfolio companies has been that the removal of dividends is a short-term measure linked to preserving cash and reducing risk as they navigate through the lockdown period. If that’s the case investors in the fund can expect income payments from the fund to bounce back strongly. The managers have been using recent inflows from investors to add to existing positions with strong balance sheets and low valuations including Eurocell, DS Smith, Galliford Try and Phoenix Group.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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