Please see the below market commentary from Brewin Dolphin from the 5th June 2020 regarding the potential role of dividends to investors:
The best laid dividend plans of companies and investors have been disrupted by the coronavirus. For many investors, this could make a significant difference in the short term. Guy Foster, our head of Research, asks whether now might be the right time to rethink the role of dividends in your portfolio.
On 30 April, Shell cut its dividend for the first time since the Second World War. The decision was seen as significant, given Shell’s then-position as the UK market’s largest dividend payer.
With this painful reminder that dividends tend to be an intention, rather than an obligation towards shareholders, some may ask themselves if this may be the time for investors who are seeking to generate an income from their investments to consider new tactics. Assessing the performance of a business on a total return basis – ie looking at any appreciation in the value of the shares, as well as the dividends – is quite a different approach, but may provide more flexibility for the future.
The role of dividends
Over recent months, shareholders around the world have been asking whether, in the face of an unprecedented period of financial stress, such dividend cuts are prescient or prejudicial – and whether companies are still working for their investors?
In the 1980s and 1990s paying a regular dividend was seen as imposing a form of discipline which prevented management from indulging in more wasteful uses of what ultimately is shareholders’ cash. Never was this in greater focus than during the temporary madness of the technology bubble, in which some companies made spectacularly badly judged investments while others, who concentrated on the steady production of a dividend, weathered the subsequent bear market far better.
Perhaps scarred by that experience, investors and companies resolved that returning cash to owners was a priority. In the UK, dividends were the means of doing this and investors have grown used to the regular payments.
However, there is a fine line between a dividend policy which imposes discipline on a company and one which becomes a straitjacket. It would be an exaggeration to see the focus on dividends as the reason for the UK’s relative dearth of fast-growing companies, but such a firm income focus does not come without its costs.
Alignment with shareholders’ long-term interests
Problems arise for businesses when they are not performing sufficiently well for their dividend payments to be for the long-term benefit of the business.
Shell were reported, earlier in the year, to be extending their credit facility in order to be able to meet their upcoming dividend payment. The question for the board would have been whether taking on additional debt to meet this payment was the right thing to do for the long-term benefit of the company. Clearly, they decided it was not and shareholders’ long-term interests were better served by retaining more capital in the business.
When pressure to maintain the dividend prevents companies from investing well, or reducing debt appropriately, then the long-term prognosis worsens for all stakeholders.
The need for financial and strategic flexibility, which a rigid dividend policy can inhibit, is heightened by the change and disruption that has become a common feature of product and service markets. A more pragmatic distribution policy, in contrast, can support that flexibility.
There have also been advances in corporate governance which mean that management are more accountable to shareholders and their compensation is increasingly aligned with factors that drive shareholders’ long-term returns. This reduces the need for a yoke-like dividend policy.
Assessing the quality of the management and their alignment with shareholders is an important part of understanding what kind of return investors can plan for.
Different attitudes to dividends
In my eyes, one of the very best private client investments is shares in Berkshire Hathaway. That is despite the company never having paid a dividend. For most of its history Berkshire has found opportunities to reinvest profits within its businesses, by buying new businesses, by buying company shares or by buying shares in Berkshire itself. Unusually, with such a strong history of excellent capital allocation, Berkshire’s management are afforded the opportunity to retain a lot of cash in the belief that they will make best use of it when opportunities present themselves. That was the case during the financial crisis and may well be the case again during this period of economic stress.
Pragmatic or well-structured policies on distribution can be indicative of a good company with a good business model, strategy and even culture. Sensible capital allocation is also observed among cyclical companies that recognise the risks and uncertainties associated with their industries. Such companies usually employ flexible dividend policies and operate with significant operational and financial buffers. Housebuilder Berkeley Group scores well on that front.
Mining companies have attempted to craft stable and growing dividends from commodity prices which are inherently volatile. They abandoned predictable dividends in favour of policies that pay out a stable percentage of potentially volatile profits. There is no question that this does increase the short-term volatility of income, but it reduces the risk of income appearing stable, only to collapse precipitously due to prevailing economic conditions.
Admiral has been one of the best dividend-paying companies in recent years. It incorporates a variable element to its pay-out. Admiral’s competitive advantage enables it to run the business with very little capital which means it can distribute almost all its profits. It does this through a growing regular dividend and frequent special dividends. The special dividends are, themselves, pretty regular, but its most recent special was delayed in April at the behest of the regulator. The attraction of Admiral to an investor wanting dividends (apart from the quality of the business) is that the interests of investors and the company are aligned. Admiral distributes profits it does not need to reinvest, and the investor provides capital upon which they need an income return.
These are all examples of great managers who inspire trust in their investors.
How best to respond?
With the shock that the global economy is undergoing currently, there will, at the very least, be a temporary pause or reduction in many dividends.
For those shareholders who have the luxury of choice, taking more of a total return approach rather than an income approach may well be in their long-term interests. It may also benefit the companies they invest in, and society at large.
For those reliant upon the returns from their portfolio to meet expenses there are some points worth discussing with your adviser. Neither the capital returns, nor the income returns, from equities are immune to volatility, as this recent period has re-emphasised. Selling stocks at low prices can have lasting implications for a portfolio. Hence, one of the greatest luxuries we can be afforded as an investor is the choice of when to raise money from a portfolio. That can be ensured by keeping a pool of cash to meet expenses should now be a judicious time to draw from the portfolio.
The research team and our investment managers are, as ever, working to establish which companies are managing their distributions sensibly and in the best long-term interests of shareholders.
Should we need to weather other financial shocks, it is likely that companies with the most pragmatic and well-considered approach to managing all aspects of their business will be the ones whose returns can deliver our long-term financial objectives.
These articles from Brewin Dolphin provide their view of the markets and potential investment strategies given the current market climate.
Dividends are an important consideration for both fund managers and investors. Different dividend strategies will need to be applied as markets adapt during and following this crisis
Paul Green
09/06/2020