Pandemic pain for dividends – HL fund manager’s view

Dividends make up a huge part of investors’ return from the UK stock market. Great companies grow over time, allowing them to raise their dividends. What starts as a small percentage yield on the initial investment can end up as a very large yield. That, of course, is when everything goes right. The arrival of Covid-19 has caused falls in stock markets around the world, and a dramatic drop in the dividends paid to investors.

Please note that this article is not personal advice. If you’re unsure that an investment is right for you, seek advice. All investments and the income they produce can fall as well as rise, so you could get back less than you invest.

The impact on companies

UK companies have reduced their dividend payments to shareholders by £24bn since the pandemic broke out. This is quite unprecedented, like so much we’ve witnessed in recent months. But the picture is less dramatic overseas. This is mainly because UK companies tend to pay out more of their earnings to shareholders, so dividend decisions are more pressing.

Companies know as little as the rest of us about the course of the pandemic. But they can model a few outcomes depending on how bad things might get. Then they can work out what could happen to their borrowings and cash flows under different circumstances.

The range of reactions from businesses has been wide. A few sectors aren’t so worried – water suppliers, food and pharmaceutical manufacturers spring to mind. However, lots of leisure and hospitality businesses could be in real trouble. Airlines have to keep funding their fleets, even as they sit grounded, causing their debts to soar unless they own the aircraft outright. Some companies have had to come to investors asking for more money to shore up their finances.

With people spending less and companies increasing their cost-cutting measures it’s only adding to the possibility of a recession.

What about government aid and how could this impact dividends?

Governments the world over have stepped up to support their economies, picking up huge welfare costs, just as tax revenues shrink. The USA has seen 36m new unemployment claims in just eight weeks, while Germany’s tax receipts are projected to fall by over €100bn.

A common trade-off for support has been that if a company asks for help through emergency loans or furlough assistance, then it must not allow funds to be handed back to shareholders. This seems fair to us – if the state’s going to support a business with fresh capital or by picking up the wage bill, it’s right that the business should maximise its own financial resilience.

What no-one knows is whether there’s a payback yet to be revealed. Governments are taking on massive debts, of which they might want to have at least some paid back in the future. For companies who’ve taken the help from the government, it raises questions about whether they can pay a dividend in the future.

We see a clear quality difference between future dividends from businesses that have been able to reward shareholders through this crisis and those that have not.

There are also businesses that have not taken state aid, but have cut their dividends on a precautionary basis. Housebuilders, some major energy companies, banks and insurers fall into this camp. Here the question is whether the market conditions they’ll face in the future will support the level of dividends they’ve been able to pay in the past.

Should house prices tumble, the builders could find it hard to make the sort of payouts they used to. If oil prices don’t recover, the same applies for energy producers. Banks and insurers will need to count the bad debts and claims that come in before working out what the sustainable level of dividend can be, if any.

For now, the ongoing yield of the market is significantly reduced. The question is when, and in what shape will dividends return?

So what does this mean for the future of dividends?

We don’t think companies that are getting help from the government will start paying dividends until they’ve stopped receiving that help.

Companies that have taken furlough aid will also have been racking up losses if they’ve been unable to trade. So they might well prioritise debt repayments ahead of dividends. Socially distanced trading might be much less profitable for leisure groups, especially if fewer customers can be served.

Take all of this together and we think that lots of the companies that have reduced their dividends won’t restart payments before the second half of 2021, if not later.

A lot depends on the development of treatments and vaccines. The more progress is made, the more the world can return to how it was. Progress here could also mean a shot in the arm for corporate health, and the ability to perhaps pay a dividend.

Investors will be picky. Just like us

We think the pandemic will have one particular long-term consequence. Investors will discriminate more carefully between companies.

Businesses that have been able to keep paying their dividends despite all that has broken out around them will be more attractive now than ever. The shift to digital business models has also been accelerated, with lots of businesses finding that the digital channel is the only way they can reach their customers during lockdown. Digital winners will be prized, and doubly so if they’ve been able to keep dividends intact.

The HL Select team have always focused on businesses with fundamentally strong business models, and features like high levels of recurring revenues and limited debts. As a result, few of our companies have had to resort to government funding. We held no airlines, hotels, pubs or restaurant companies across our range.

We think that to achieve high returns in those areas you need to borrow a lot. We also think that these types of companies have a lack of recurring revenues and are too cyclical. This means that they’re more exposed to movements in the wider economy – when the economy does well they do well, when the economy goes down so do they.

We have taken some hits though. Notably Royal Dutch Shell which cut its dividend for the first time since World War 2, and the few banks that we hold are barred from paying by the regulator. But other names like Unilever, Diageo and Relx, have continued making payments to their shareholders.

Long may that continue, though as ever, remember all dividends are variable and there are no guarantees.

Find out more about HL Select Funds

The HL Select Funds are managed by our sister company HL Fund Managers Ltd.

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