Injecting hope into UK equities

For any UK investor reviewing 2020 and the falls seen in the FTSE All Share, and particularly dividend cuts, one’s attention naturally turns to the outlook for dividends from here and any lessons we may have learned.

One place to start is the recent past for clues about what the future may hold. Following the global financial crisis (GFC) of 2008/09, dividends paid by FTSE All Share constituents fell 21% from a peak in August 2008 to a trough in October 2009. The good news is that from the lows, the All Share Index’s dividends rebounded 60% over the subsequent 5 years and surpassed their 2008 peak just 4 years later, in early 2012.

Fast forward to today and the FTSE All Share’s dividend yield stood at 2.9% at the end of March, having fallen just under 35% over the prior year. However, we see grounds for optimism based on history and a successful roll out of vaccines in the UK.

We feel that dividends will see a vigorous rebound in the coming years, and our optimism is broad based. Firstly, the strong progress with the vaccination program - over 60% of the UK population has received a first dose and 14% a second dose - means economic activity and corporate cashflows are already starting to recover quickly.

In contrast to the period following the GFC, household balance sheets are in a much better financial position today. Consumer savings rates have been boosted by enforced lockdowns and these savings represent a pent-up spending impulse that will benefit the economy. Alongside this, corporate profitability has already started to inflect upwards.

Offsetting the good news is the potential for unemployment to rise as the UK’s furlough scheme ends in September, while rising corporation taxes will absorb corporate free cashflow. However, these negative factors are unlikely to derail the overall upturn in corporate profits. Importantly, the boards of UK companies understand the demand for dividends from shareholders (and the role they play in the compounding of returns), especially with interest rates on savings products at negligible levels.

Crucially for investors, many of those companies that have cut dividends have publicly stated their desire to resume dividend growth as soon as profits, cashflows and debt permit.

In common with other managers, we made some changes to the fund in recent months, taking advantage of share price falls to buy into cash generative companies with, we believe, excellent futures.

We added holdings in food on the go retailer Greggs, Compass Group, the global leader in food service, and the UK’s largest direct to consumer investment platform, Hargreaves Lansdown. We believe all three have distinct barriers to entry, whether its Gregg’s low prices that provide great value for money, Compass Group’s international scale and specialisation, or Hargreaves Lansdown’s brand which is trusted by over 1.5 million customers.

The eagle-eyed will spot that only Hargreaves Lansdown currently pays dividends. The other two have been impacted by lockdowns restricting travel and a return to offices, hitting revenues and causing them to suspend dividends. However, when analysing companies our primary goal is to understand a business and its long-term competitive advantages. Given the opportunity to buy some great businesses where dividends were suspended, we also studied their pre-pandemic dividend track records. All three generated strong returns on capital in the prior decade, allowing them to invest into growing the business while having enough cashflow left over to distribute dividends to shareholders. All three grew their dividends at over 9% p.a. in the ten years preceding the pandemic, well ahead of inflation.

Another consideration we took into account were companies debt levels. We believe that companies are likely to prioritise lower levels of debt to cashflow going forwards. For many consumer-facing companies the first national lockdown was a catastrophic experience, and there remains the potential for future flash lockdowns. As such, corporate boards with higher than desired debt levels are likely to err on the side of caution, preferring to reduce debt than return to the dividend list.

Against this criteria, Hargreaves Lansdown and Greggs have net cash on their balance sheets, while Compass Group raised £2bn from investors in May 2020 and is now cash generative following a period of restructuring. We feel confident that Greggs and Compass Group can return to the dividend register before too long.    

One of the over-riding lessons we were all reminded of in 2020 was the value of patience, whether you are an income investor or a growth investor. The decline in the FTSE All Share in March 2020 was particularly precipitous, falling 15% as fear took hold of the deleterious effects that COVID-19 would wreak on economies. However, the rebound was no less dramatic, with the All Share Index now only 2% down if dividends are included from the end of 2019. It is a reminder that investing should not be viewed as a short-term activity as the volatility over shorter periods can be high.