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The coronavirus cash conundrum – a stock picker's guide to dividends

Equity Analyst Sophie Lund-Yates explores what coronavirus means for UK dividends, and what income investors should look for.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Dividends are a nice to have, not an essential business expense. That means they get cut in challenging times.

The amount of dividend cuts we've seen in recent months is exceptional. The cancellation of shareholder pay-outs used to be fairly rare – a sign a company was in real difficulty. But cuts have become the norm over the last few months, as businesses rush to preserve cash in the face of uncertainty. By mid-May the amount of dividends that had been scrapped or delayed by the UK's biggest listed companies topped £30bn. Even companies with long track records, – traditional staples in income and pension-fund portfolios – decided to cut.

The biggest status-quo shaker was Royal Dutch Shell. The oil & gas giant cut its dividend by two thirds – the first cut since World War II. Companies like Shell will try to do everything they can to maintain their pay-out record. It wasn't a decision they took lightly.

This article isn't personal advice. If you're not sure if an investment is right for you, please seek advice. All investments and their income fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future. Figures and ratios should not be looked at in isolation.

What's different this time?

This time dividend cuts are all about keeping balance sheets air tight.

Companies want to keep hold of the cash they do have, in case the difficult conditions mean they need this cash to keep the lights on. Some of the recent dividend cuts are more precautionary, not reactionary.

In some industries there's been another layer of pressure – the regulators stepped in. The Financial Conduct Authority asked the UK's major banks to scrap their dividends, because it's better that cash is kept in these crucial businesses during such turbulent times. The forced suspension of dividends is certainly not a normal state of affairs.

It all sounds very doom and gloom, but lots of companies are having a dividend hiatus rather than a long-term cut. This brings us to a question we get asked a lot on the Share Research team.

When are dividends going to recover?

Anyone that says they know this for sure isn't being truthful. There's still swathes of uncertainty in the economy and markets, and there are lots of things to consider.

The biggest thing to think about is how exposed a particular sector is to the current disruption. Airlines are going to be more severely affected, and for a longer period of time than supermarkets, for example.

So called “cyclical” companies – businesses whose fortunes wax and wane more closely with the economy – are going to be more conservative with their cash, and dividends will take longer to come back.

The way we traditionally measure dividend sustainability has also changed.

Usually we'd look at dividend cover – a metric used to see how well (or not well) dividend payments are covered by profits or cash flow. We wrote about these measures and how they work in more detail back in February.

3 ways to check if a dividend is sustainable

The details are in balance sheets

In the current state-of-play, it's impossible for companies to predict when profits or cash flow might stabilise. That means it's even more important to look at the balance sheet too.

This is where you'll find details of a company's assets – like cash in the bank, and liabilities (debts). Looking at a net debt number (cash and cash equivalents, minus debts) will give you an idea of how financially comfortable a business is.

There's no hard and fast rule, but we'd usually say that a net debt to cash profit – also known as EBITDA (which can usually be found in the income statement) – ratio of around 1 – 2 is sensible. Ideally cyclical companies want this at the lower end of that range.

No dividend is guaranteed. However, looking at the balance sheet like this could provide investors with some idea of whether a dividend in the short-to-medium term is a realistic possibility.

A company struggling under a huge debt pile is a lot less likely to pay a dividend than those businesses with low or no debts. For the latter two, it's worth looking at how much the dividend pay-out cost the business in previous year. Even companies with a net cash pile might not pay a dividend, especially if it's being cautious, but it's more of a likelihood than a company that owes lots of money.

It's also worth taking the time to understand if the group's earmarked major spending for another purpose. For example, net debt compared to EBITDA could look sensible. But the group might have just announced a new strategy or expensive investment programme – there's a chance dividends could be on the back burner for a while longer.

What should investors remember?

Understanding whether a dividend is likely to be paid, or forthcoming, is trickier today than it usually is.

Investors should remember this current crisis is about balance sheet preservation and cash management more than anything. It's the first place we should look to understand if a company is willing, or able, to open its purse strings and dish out returns to shareholders any time soon.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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