Why UK dividend cuts may be a good thing

The UK equity market has seen a plethora of dividend cuts and rights issues in the wake of the Covid-19 pandemic and associated economic shutdown.

As a result, dividend income may be limited in 2020, but in the long-term, these cuts could be good news for UK businesses, according to some Elite Rated managers.

We caught up with five fund managers to get an update on UK Equity Income.

Why might the cuts be a good thing?

“Whilst obviously not great for those investors relying on the income from their shares, the rebasing of dividends across the UK stock market is an opportunity for companies to reallocate capital more sensibly,” said Carl Stick, manager of Rathbone Income fund.

“Some businesses have been over-distributing in recent years with yields of 7-10%. For example, Shell had unwieldy debt and an unstable market, but had continued to increase its dividend until recently. This has now changed and hopefully the cuts will get people thinking more about quality of earnings and companies will reinvest in their business, instead of gearing up to pay a dividend. I think this is a good thing.”

Richard Colwell, manager of Threadneedle UK Equity Income, added: “Some companies played to their audience and paid dividends when perhaps they shouldn’t have done. But the media portrayal of dividends as ‘fat cat’ paydays belies their critical role in pensions, savings and income of the British public.

“We were overdue some cuts. This is a process which comes about at the end of every economic cycle, but this time it was condensed into three weeks and no part of the market has been immune.”

“In ordinary times, a dividend cut is a sign of failure. In these exceptional circumstances, however, it reflects sensible short-term capital allocation,” agreed Martin Cholwill, manager of Royal London UK Equity Income fund.

“The pandemic has resulted in a great deal of uncertainty for all businesses. Even those whose trading has been unaffected, have still faced issues with supply chains and distribution networks. So reducing capital expenditures like dividends is prudent. There have been some big cuts but what is key is what happens over the longer term.”

What’s the outlook for UK dividends longer term?

“Dividends will be back, but for now, balance sheets and liquidity are paramount,” said Richard Colwell. “Even in our worst case scenario, the UK market should still offer a healthy premium to bonds by next year. The overall level of dividend payments will be lower, but I expect more prudent policies from companies and much better cover. The dividend – when paid – will be more secure. Dividends will be back, but for now, balance sheets and liquidity are paramount.

“The lesson I learned from 2009 (the last time dividends were cut substantially) is that some of the best contributors of total return came from capturing growth before companies returned to dividend payments. Corporate refinancing in the financial crisis also yielded some of the greatest shareholder returns.”

Adrian Gosden, manager of GAM UK Equity Income, added: “Clearly, the equity income model has come under pressure. While in most cases we do not think earnings of 2019 will be repeated this year, we are optimistic that companies with the right business models to be back to 2019 earnings levels in 2021/2022. Similarly, while dividends have taken a hit in 2020, we believe that they should return within 12-24 months, albeit perhaps less generous in some cases. This is ultimately a call on the individual companies and their management teams.

“Despite the harsh environment, we foresee dividends returning and continuing to be the most important driver of total equity returns over the long term. In the meantime, equity income investing looks likely to continue to prove beneficial for investors prepared to hold their nerve.”

Job Curtis, manager of City of London investment trust, is also reasonably optimistic about the longer term outlook. “I’m hopeful for dividends going forward – unless we get a second wave in Autumn, although governments and economies should also be more prepared for this,” he said. “Overall, for dividend paying stocks, the outlook is good.

“Some parts of economy will be slow to recover, like travel and leisure. Banking too. So, I’ve reduced exposure to these areas. Instead I favour consumer staples – companies providing the basic, everyday goods we need to buy – and the supermarkets. They make up around a quarter of the portfolio. Dividends have also held up with life assurers, so I’ve added exposure here too. I also have 9% in pharmaceuticals and healthcare, 6% in utilities and 5% in telcoms. So, it’s a good foundation of solid companies and relatively defensive.

“There is also recovery potential as we come out of lockdown and I anticipate a fair amount of economic recovery. So the portfolio also has a balance with positions in areas where there is this potential.”

Martin Cholwill is also upbeat. “We’re entering quite a significant recession and, while there are huge uncertainties, if governments get things right, dividends could come back very quickly,” he said. “Once we’re through lockdown, some of the companies I have talked to could reinstate dividends materially.”

How will the funds’ income distributions hold up?

“There will be a cut to the dividend on the Rathbone Income fund this year,” said Carl Stick. “But I expect it to be less than the overall market. I own some businesses that have cut their payouts, but I’ve also had some positive surprises. The big swing factor will be BP” I’ve factored in a 50% cut, so if it’s less the fund’s income will be higher.”

“Even if dividends do come down by 50%, the Royal London UK Equity Income fund will still yield over 3%,” said Martin Cholwill. “That’s not unattractive and still reasonable compared with many other asset classes. So there’s still a place for UK equities in a client’s income portfolio.”

Job Curtis concluded: “The good thing about investment trusts is that they can put income into a revenue reserve for rainy days like this. The board of City of London has announced it will use its revenue reserve, if necessary, to maintain the trust’s dividend payout.”