21 May 2020
The coronavirus (COVID-19) crisis and oil price woes are having a profound impact on economic growth and the cash position of companies. With earnings expected to be negatively impacted across many sectors and regions, the ability of companies to pay out planned or expected dividends is understandably being questioned. Furthermore, some governments have applied indirect or direct pressure to certain industries to reconsider their dividend pay-outs on the basis that, in their view, in this time of financial difficulty for many people, shareholders should not be rewarded.
As a result, across the market, we have seen a number of companies cut, cancel or suspend dividends.
Figure 1: FTSE 100 dividend cuts
Source: Dividend data 30 April 2020. Dividends cut, cancelled or suspended of FTSE 100 companies between 20 March 2020 and 30 April 2020.
With our income strategies focused on the selection of individual positions that offer an attractive and sustainable income, we are clearly alert to these developments. Our explicit focus on the resilience of dividend payments within equities means this risk is less acute compared to other approaches. We therefore expect, at this point, the majority of the stocks we own to at least maintain their dividends in the current fiscal year. For those that do not, we see suspensions as temporary (driven either by discretionary choice or regulatory instruction) and believe this is reflected in their valuations.
We continually focus on identifying and avoiding those companies that are facing fundamental pressure in the longer term and from this perspective we believe our holdings are well placed.
The S&P Global Dividend Aristocrats Index is commonly used as the basis to implement equity income strategies and so we deem it useful here for comparison purposes only. It contains the highest dividend yielding companies across global markets, which have also followed a policy of increasing or keeping stable their dividends for ten consecutive years. We believe this is an imperfect way to capture the opportunity presented by higher dividend strategies as it can lead to investors allocating capital to companies that take on leverage to maintain dividends rather than those who do so based on the resilience of their business model. Selecting stocks based on yield alone incentivises the willingness to pay out dividends without thinking about the appropriateness of doing so.
Our philosophy is that companies with resilient income generation provide better risk-adjusted returns over the long term because they are quality businesses. It is not orientated towards simply the highest levels of yield. Resilience is a product of the profitability of the company and its capital allocation decisions. We measure a company’s dividend sustainability both quantitatively and qualitatively, focusing on factors such as profitability, leverage and dividend sustainability. We believe our bottom-up focus on resilient and sustainable yields has helped us build a portfolio of companies that is highly differentiated versus such dividend benchmarks, as illustrated by the sector comparison below.
Figure 2: Sector comparison of 'ours' versus 'theirs'
Source: Ninety One, Bloomberg 30 April 2020. ‘Dividend Aristocrats’ represented by SPDR S&P Global Dividend Aristocrats UCITS ETF.
Most notably our approach comprises more stable and high-quality business that leave us better placed to navigate the current environment. This can be seen in some commonly encountered financial metrics: our portfolio has around 0.9x net debt to equity (leverage) on average, whereas the S&P Global Dividend Aristocrats Index has a leverage of 1.4x.
As such, we believe the companies we hold have an appropriate level of leverage to support their businesses and to optimise their capital allocation. Importantly, they have largely avoided the trend of increasing leverage to fund unsustainable dividends or buybacks.
Our equity selection process includes a quantitative assessment of the investment universe that incorporates aspects such as income sustainability, along with the qualitative fundamental input from our analysts. Companies that score lowly on our process and/or do not retain the conviction from our analysts will be sold for higher scoring alternatives. We aim to differentiate between short term transitory weakness and signs of longer-term fundamental pressure. We are willing to look through shorter-term weakness if we are confident in the long-term income sustainability, although we will sell a company even if valuations are more appealing if we believe that the dividend sustainability is weaker.
April saw relatively meaningful turnover in the equity portfolio as the recent market decline offered the opportunity to buy high-quality companies at discounted valuations. For example, we added to defensive companies such as Pepsi, Enel, BAT and Iberdrola, that we believed had seen an unwarranted de-rating, and initiated a position in Home Depot, a high-quality dividend compounder. Below are examples of two of the changes made.
Walmart de Mexico – the Mexican and Central American Walmart division – was sold based on low scores across our metrics following outperformance.
The company is the largest home improvement retailer in the United States. It displayed bottom-up signs that home improvement is strong, as well as the stock being a stable dividend compounder.
Looking forward, as income investors, we have confidence in the market ahead of us. We believe our bottom-up process and focus on dividend sustainability will see us continue to hold higher-quality companies that generate attractive income streams over the long-term, and so are well placed for the environment ahead.