I have experienced several market corrections in my three-decade investment career and the one we endured early in 2020 was one of the most challenging yet. During the peak uncertainty in March my advice to investors was clear: try your very best to resist knee jerk reactions. We take a long-term view on investing and this didn’t change during Covid-19. Six months later, I can report on early evidence to show that this mind-set is paying off again. 
The easing of lockdown measures (in late spring/early summer here in Europe) has been followed by a good recovery in global economic activity. Worryingly, however, we’ve also seen a pick-up in infection rates in a number of territories necessitating the re-imposition of some restrictions.
Despite the ongoing uncertainty, many companies are getting back on track, looking to the future and feeling sufficiently confident to give some guidance on their likely financial performance for the rest of 2020. Where appropriate, a number of companies have also resumed the payment of dividends they deferred in the spring.
Other positive evidence for UK companies includes the unveiling of new investment plans and some sensible mergers and acquisition (M&A) proposals. What we’ve found is that the strongest companies are well-placed to consolidate their positions following the crisis. Incidentally, it is good to see the resumption of bid interest in UK equities from overseas buyers as global deal making begins its road to recovery.
When reflecting on a tumultuous spring and summer, I would highlight the following seven reasons for optimism around UK quoted companies and their dividends.
1. The instances of positive news have been obscured by a focus on high profile dividend cuts
That 2020 will be a bad year for dividends is not in debate, however some pretty dire scenarios for dividend cuts have been tempered since the early spring. Forecasts in April/May that global dividends might fall by up to a third versus 2019 levels have since been significantly pared back.
Those who have taken a measured and long-term investment view during this crisis have already, quite literally, reaped the dividends as they’ve correctly judged which payments were less vulnerable than the market had feared.
To pick out just one example, the decision by Tesco to pay a materially higher final dividend this year is worth exploring.
Clearly the company has benefited from its essential retailer status. However, there has been much hard work behind the scenes over the past few years under the (now outgoing) CEO Dave Lewis. This has helped to rebuild customer loyalty and drive volume growth. Additionally, the agreement in March to sell Tesco’s Asia division for a good price has done much to strengthen the company’s financial position, or balance sheet.
Other resilient business, such as GlaxoSmithKline and defence group BAE Systems (see below) have also continued to pay dividends. Headlines such as “Shell Cuts Dividend for First Time Since World War Two” have helped put cuts front of mind, while the payment of a record $3.7bn final ordinary dividend by Rio Tinto passed by without comment. Meanwhile, “Now BT takes the axe to its dividend: Shareholders will get no annual payout for first time since 1984 privatisation” may have given the impression of endless cuts.
With Covid-19 far from over, from an investment perspective it’s worth remembering the natural tendency in us all to sometimes focus on the negatives, to the exclusion of all else. In our opinion, the resilience of the strongest companies with the strongest balance sheets will increasingly come into focus with time and the benefit of hindsight.
2. The timing of the first wave of the pandemic contributed to the gloomy prognosis
We’ve not had a global pandemic in more than 100 years, so you can understand why many company boards were initially very protective of their balance sheets – BAE, for instance, initially deferred its final dividend for 2019 which it subsequently paid on 14 September, to those who had held the shares prior to the ex-dividend date of 6 August.
The timing of the pandemic contributed to the level of cautiousness. When in early March the World Health Organization declared a global pandemic, a large proportion of companies had already declared their final dividends for 2019. We were approaching the AGM season with late March and April dividend payment dates looming – there was not an awful lot of time for boards to consider the merits, or otherwise, of revising dividend recommendations to shareholders.
Using our own experience, we supported boards taking a measured approach, where appropriate – in the case of personal and commercial insurance provider Direct Line, for instance, this contributed to the board’s decision to keep the final dividend payment under review, rather than cancel it.
3. Companies and shareholders have worked together well
We initiated a position in Direct Line in May 2020 at a very attractive valuation. The company published a reassuring set of interim results in August, revealing that it had not been adversely affected by Covid-19. As a consequence, not only was the board able to confidently declare an interim dividend of 7.4p a share (2.8 per cent ahead of last year’s interim payment) but it also proposed a special catch-up payment, to fully cover the stalled 2019 final – a positive contribution for all shareholders in the company at that time.
These payments reflect the strength of Direct Line’s balance sheet, not least because the company has been able to return cash and comfortably meet ‘capital adequacy’ rules. Capital adequacy rules stipulate the amount of additional funds insurance companies should hold on their balance sheets. These funds are to shield the companies, their policyholders and other financial counterparties in the event of a deep recession or economic dislocation, such as that caused by Covid-19.
4. Governments and central banks have taken lessons from the past
Some pretty catastrophic scenarios were being envisaged in March. Remember, efforts to contain the virus had hit economic activity indiscriminately, everywhere, all at the same time. There was a real fear that many companies would fail.
This was also reflected in very bleak sentiment towards the life insurance companies, to take another example. In order to cover future payments to their policyholders (liabilities), life insurers hold corporate bonds for which the risk is that companies default.
The dire conditions for companies seemed certain at the time to have consequences for insurers’ capital adequacy. In addition, there were fears that the fall in government bond yields following the crisis might have a negative impact as lower rates increase the valuations of insurers’ liabilities, as well as the valuations of the corporate bond assets backing them.
However, governments and central banks took lessons from the past and were, thankfully, quick to offer significant support for individuals, economies and the financial system – the benefits of these actions have been clearly reflected in narrowing credit spreads.
The credit spread is the margin that a company issuing a bond has to pay an investor in excess of government yields and is a measure of how risky the market perceives the borrower to be. The chart below tracks credit spreads for the ‘high yield’, or riskier corporate bonds and lower risk ‘investment grade’ corporate bonds.
5. Markets have rewarded stockpickers
The share price of insurer M&G fell more than 40 per cent in March, which seemed to us an excessively large fall. There are many valuation metrics and many ways in which these metrics can be compared (whether on a relative or absolute basis) in order to judge if a company is mispriced. When a prospective investment, however, offers a dividend yield of 16 per cent (as did M&G at its share price lows) we’re firmly in the realm of absolute value which, ordinarily, one might think too good to be true.
We took a view that the circumstances were extraordinary and that dividends would, in fact, be paid this year, and be sustainable in future years. There were a number of technical factors which meant sellers of the shares were out in force at the time. Meanwhile, gating of the group’s property funds (a temporary measure to limit redemptions in a fund during difficult times, especially one with illiquid assets) and redemptions from a high-profile product hit sentiment more than the economic impact might have warranted.
We decided to initiate a position after combining these observations with our fundamental analysis. This analysis indicated that the cash generated by M&G’s legacy annuity business would largely cover dividend payments. In our opinion, the company was able to make these payments and satisfy capital adequacy rules. In late May, the company confirmed an inaugural final dividend of 11.92p a share, and a “special demerger dividend” of 3.85p following its successful separation from Asian-focused insurer Prudential in late 2019.
Prudential and Legal & General have also paid in full their final dividends declared prior to the crisis, although it should be noted that Prudential’s final payment for 2019 was rebased lower to reflect the demerger of M&G. All of these positives were less visible at the time than was the negative of Aviva withdrawing in early April its recommendation to pay a final dividend for 2019.
6. Many more individual mispriced opportunities remain for both income and capital growth
The recovery in M&G underlines how mispriced opportunities can offer both good income and capital growth prospects. With Brexit in the background - and Covid-19 creating ongoing challenges for the domestic UK economy - sentiment towards UK equities remains poor. Global investors are not, however, discriminating between internationally focused companies and the domestically focused ones which we believe face a more uncertain outlook.
Of all the regions, we are perhaps most optimistic about the growth outlook for Asia where many countries have previous experience of virus containment, better contact tracing programmes and younger, healthier populations. Once it has demerged the US business, Prudential, for example, will be squarely focused on the expanding Asian middle class which is driving spending on healthcare and pension products, opportunities not properly reflected in the valuation in our view.
The UK equity market’s overlooked status has also created a relative valuation opportunity in a specialist distributor of plumbing and heating products, Ferguson. The company operates almost exclusively in North America but trades on a lower price-to-earnings multiple versus its US peers. In this context, news earlier this year that it will seek approval for an additional listing in the US in 2021 made perfect sense.
7. Investors who are able to be patient should benefit the most
Sometimes it takes external events to wake investors up to a mispriced opportunity. We’ve seen this with security company G4S which, earlier this month, rejected a bid approach from private equity backed and Montreal headquartered peer Garda World. Prior to the bid, and before Covid-19, we pushed for the sale (in preference to a demerger) of G4S’s cash solutions business, culminating in Brinks purchasing it for £660m in February. As a result of a strengthened balance sheet, simplified structure, emerging markets’ exposure and investment in new technologies, G4S’s long-term prospects look good. In time we expect it to return to paying a dividend at an attractive level.
As a holder of 10 per cent of G4S shares, we believe that the bid proposed by Garda World and BC Partners materially undervalues G4S and its prospects. However, we are open to a deal at a fair price that more accurately reflects peer multiples, synergies and other strategic benefits that an acquirer will gain from.
More broadly, it is encouraging at an overall level to see the resumption of interest in UK equities by large and experienced long-term investors.
William Hill is another company where we’re willing to be patient investors. The gaming group is in a good competitive position to expand in the US – paying a dividend now could well curtail its ability to maximise these opportunities.
These situations are very different to those in the oil and telecoms sectors, for instance, where the crisis has exposed pre-existing weaknesses. Despite the initially positive market response to BP cutting its dividend, the company’s transition from fossil fuels to clean energy will take time and the lower oil price environment is compounding the uncertainties which face it.
Sue Noffke is manager of the Schroder Income Growth investment trust. The views expressed above are her own and should not be taken as investment advice.