What do dividend cuts mean for UK equity income investors post-COVID-19?
The impact of the coronavirus pandemic has been significant so far, with many countries around the world having swiftly entered a recession during the first half of 2020. Government-mandated social distancing measures have created new and difficult challenges for companies – from supply chain disruption to the accelerated growth in e-commerce, businesses are having to move at pace in order to cater to the needs of consumers in this uncertain environment.
Many UK-listed companies have put in place measures to conserve cash. Management teams have taken the difficult step of furloughing employees, funds have been drawn down from banks, all non-essential expenditure curtailed, and dividends cancelled across a range of sectors.
However, we believe there are reasons to remain optimistic about dividend income over the long term in this low interest rate environment.
George Luckraft, Portfolio Manager of the AXA Framlington Monthly Income Fund, and Simon Young, Portfolio Manager of the AXA Framlington UK Equity Income Fund, delve into the challenges faced by equity income funds, and the opportunities they believe the COVID-19 crisis presents.
Given the widespread dividend cuts throughout UK markets, how much are they likely to fall and will they return to previous levels?
George Luckraft (GL): I suspect they may fall by 40-50% in 2020. We have already seen some well-known companies reduce their payments to investors. Royal Dutch Shell cut its dividend by two-thirds1 , while BP has just announced a halving of its dividend.2 Companies are being rational with their dividend cuts in ensuring that balance sheets are strong and by concentrating on liquidity. As we go through the year, I expect companies which weren’t as affected by conditions during the crisis may pay some of their deferred dividends. This is a trend we are starting to see with Rotork, St. James’s Place and Sabre Insurance to name a few, announcing in their latest quarterly reports that they would pay previously deferred dividends. Therefore, I think there will be a pick-up in news later in 2020, although returning to previous levels will take some time. I believe 2021 will be a better year, and my view is that we will see a recovery in the following year.
The index is dominated by some key dividend players. Will this signal the end of the skew?
Simon Young (SY): The dividends paid by companies in the FTSE All-Share are predominantly generated by the top 15-20 companies. The economic repercussions of COVID-19 will see overall dividends paid fall and the skew towards the largest companies fall. If you disaggregate the FTSE All-Share Index last year, just over £100bn was paid out by all constituents. Within that, the top five payers – Royal Dutch Shell, HSBC, BP, Rio Tinto and British American Tobacco – accounted for one-third of all FTSE All-Share dividends. The top two have already cut their dividends – Royal Dutch Shell by 65% and HSBC, following regulatory intervention from the Prudential Regulation Authority, has suspended its dividend payment for 2020, with 2021 a moot point. Those two actions alone will reduce the contribution from top five constituents; however, if we go further down and focus on the top 15, which account for around two-thirds of all dividends paid in 2019, Lloyds Bank and Royal Bank of Scotland have cancelled their dividends, while Imperial Brands cut its dividend by one-third in May. So, it wouldn’t surprise me if the dividend contribution from the top 15 companies falls from two-thirds to below 40%.3
Do you think companies had a culture of over-distributing?
SY: I wouldn’t say it’s a culture of overdistribution, but we’ve seen high-profile cuts over the years where business models have been challenged; for example, Marks & Spencer having to reallocate cash resources from paying its dividend to investing in its online joint venture with Ocado, as people increasingly shop online. As bottom-up fund managers, we are less concerned about the wider index, we concentrate on the holdings in the Fund. It is fair to say that dividends will come further down the priority list for companies following the COVID-19 outbreak. Company management is more likely to prioritise the health of the balance sheet, reducing any build-up in balance sheet debt that may have accrued if the business has been unable to operate during the country-wide lockdown. We expect companies to also invest in their businesses, especially where it increases resilience in the event of a second wave, to minimise the overall impact. It is clear to me that some sectors such as banks or shopping centres within commercial real estate will emerge with structurally lower levels of profitability and that dividends are likely to resume at much lower levels than prior to the crisis.
Governments have been instrumental in the shutdown of the economy. How do you think they will transform the economy going forward?
GL: In my view, they should concentrate on a few key aspects. I believe their main focus would be job creation. The pandemic will undoubtedly result in a rise in unemployment which is currently being concealed by the government’s furlough scheme. This could be addressed through the creation of jobs in infrastructure – new housing and perhaps a green deal to improve the efficiency of houses around the country. Another focal point is likely to be around supporting new and emerging technologies, such as 5G communications. The pandemic has highlighted the key role played by technology, with innovations like 5G offering greater speed, capacity and lower latency, which could prove useful in an environment where remote working has become the new norm. Furthermore, with the global adoption of smartphones, consumers in developed and emerging markets have become ever more connected, which is essential at a time when the global population is spending more time at home due to the pandemic.
What is your view on the government’s move to intervene and soften dividend payments?
SY: The Treasury and the Bank of England rightly stepped in towards the start of the crisis to channel money to consumers and businesses through a variety of means, such as the furlough scheme, bounce-back loans or business interruption loans. Without this intervention the economic consequences could have been far worse. The quid pro quo for accepting this assistance has been that recipient companies have deferred or cancelled dividends. As well as this, there has been some regulatory pressure. The banking regulator, the Prudential Regulation Authority, actually wrote to the major UK banks to request (that’s regulator speak for an order) that they cancel proposed dividend distributions at the end of March. Interestingly, we are now starting to see some companies such as Games Workshop pay back furlough monies and resume dividends.
Smaller companies have traditionally been perceived as economically sensitive, do you think their dividends could be at risk, given the sudden slowdown in the economy?
GL: It has been clear that every level of the market cap spectrum has been vulnerable to dividend cuts, especially if the business is economically sensitive. Companies have rightly been concentrating on liquidity. Many companies have temporarily deferred dividend payments – for example, Central Asia Metals and FDM Group. One of the features of our investment style is that we focus on the leaders of their sectors, which, especially if well financed, could come through this period even stronger.
How will you be playing a market recovery?
SY: We don’t play the recovery per se. It’s about sticking to our investment process and, in the case of the AXA Framlington UK Equity Income Fund that I manage, focusing on companies with high and sustainable barriers to entry. For example, we took advantage of weak prices in March to begin a position in a small company called Bioventix4 . The company creates and supplies monoclonal antibodies which are used in blood testing around the world – something that I think will increase going forward. The share price had fallen, and we used this weakness to establish a position.
One area that I think will benefit from COVID-19 is the non-life insurance sector. Property catastrophe insurance rates have been strengthening for the last 12 months following a series of large insured losses like super-typhoon Hagibis, which affected the 2019 Rugby World Cup, or 2018’s California wild fires. More recently, the industry has suffered COVID-19 related losses for business interruption combined with higher losses in other insurance lines such as liability. The combination of these losses has resulted in insurance rates strengthening further in 2020 and we expect profits to be positively impacted. Within this area we prefer companies that will benefit from rising insurance rates but without the exposure to liability or medical malpractice, where underwriting reserves may need further strengthening. We believe the sector has a good track record of returning profits generated in a ‘hard market’ to shareholders via dividends.
As ESG is becoming an increasingly important factor in the investment management world, what impact does it have on managing an equity income fund?
GL: Given that historically a large percentage of the market’s yield has come from the tobacco and oil sectors, ESG could be considered an issue for income funds. Fundamentally, ESG has been part of our investment process for a very long time. When you’re investing in a company, in essence you’re lending money to that management, so there needs to be a level of trust with management teams to act in the correct way. The businesses’ processes must be ethical, and therefore we have always been involved in the ‘G’ (Governance) side – as well as the ‘S’ (Social) side. The Environmental (‘E’) part is something we have increasingly been taking on board in trying to combine the best of all worlds. It should be noted that, as the importance of ESG in the investment management world grows, high carbon-emitting companies have made efforts to contribute to a lower carbon future. For example, BP has set out an ambition to become net zero by or before 2050, fundamentally changing their organisation to be able to deliver on this. We believe that regular engagement with company management acts as a very important tool that we, as active managers, use to influence and guide businesses in setting best practices across all areas of ESG.
What are your thoughts on the future of this sector?
SY: Undoubtedly the recent headlines surrounding the sector have been terrible. But looking behind the headlines does show good performance from a number of fund managers. We have seen that over a 10-year and 15-year investment horizon, the median fund in the sector has outperformed the broader market, net of fees5 . You certainly do not get that impression when reading the investment press. Taking a step back, we should ask what the rationale is behind investing in income funds. I believe this is because investors are looking for cash-generative companies that can pay dividends: we like growth, but we really like cash-backed growth, i.e. companies that can grow their revenues and cashflows over the long term.
GL: One of the most encouraging things I take from frequent management meetings is their recognition of returning to dividend-paying ways. Businesses understand the importance of deliverance.
Investing in the UK equity income sector at AXA IM
The UK equity investment team’s expertise spans the entire market cap spectrum, with average experience in the UK equity income investment team spanning more than 20 years. Our Funds typically have a long-term investment horizon, focusing on businesses we understand and whose management teams have a proven track record of stewarding investors’ capital.
AXA Framlington UK Equity Income
AXA Framlington Monthly Income Fund
Taking a long-term view in the UK equity income market
Since the outbreak of coronavirus, one thing that has been clear is the accommodative policy adopted by the government in the form of sizeable monetary and fiscal support, as well as quantitative easing from the Bank of England. Ultimately, a question remains on whether inflation will return, which could be seen as a disaster with the 10-year gilt yielding 0.12%6 .
There has been a wall of fundraising as companies look to repair their balance sheets – we believe that this must be led by active fund managers, as passive managers simply follow the weightings in the market, so they therefore cannot be at the forefront of these fundraises. The capital raised is vital for British businesses, and we feel the regulator should recognise the value that active managers bring to the table.
AXA Framlington UK Equity Income Fund
Concentration Risk: as this Fund may, from time to time, hold relatively few investments, it may be subject to greater fluctuations in value than a fund holding a larger number of investments.
AXA Framlington Monthly Income Fund
Liquidity Risk: some investments may trade infrequently and in small volumes. As a result the Fund Manager may not be able to sell at a preferred time or volume or at a price close to the last quoted valuation. The Fund Manager may be forced to sell a number of such investments as a result of a large redemption of units in the Fund. Depending on market conditions, this could lead to a significant drop in the Fund's value and in extreme circumstances lead the Fund to be unable to meet its redemptions. Further explanation of the risks associated with an investment in this Fund can be found in the prospectus.
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