Oil & gas giants Royal Dutch Shell and BP have unsustainable dividends financed by debt and asset disposal, according to FE Alpha Manager Neil Woodford.
The manager wrote in a recent blog post that while the shares are widely held by other income managers, the sector remains unattractive as the threat of dividend cuts hangs above them.
Woodford explained: “It is the walk of shame for any board and executive management to cut the dividend – it is a last resort, and rightly so.
“By contrast, companies that choose to sustain and grow their dividends, are doing so in the knowledge that they are creating a bigger burden for the future – they need to be confident in the sustainability of the business and its future growth prospects, in order to do so.”
However, the manager says it can also create further problems when companies try to avoid cutting a dividend and can lead to them potentially storing up trouble for the future.
Woodford says there are examples in the oil & gas sector with both BP and Royal Dutch Shell, who have “unsustainable dividends that are being financed by a combination of debt and asset disposal”.
He said: “In effect, these companies are liquidating themselves rather than facing up to the need for a dividend cut.
“The only thing that can save them from that eventuality, in my opinion, is a return to sustainably higher oil prices – something that I think is very unlikely to happen.”
Performance of Brent crude oil index over 5yrs
Source FE Analytics
The manager says he instead prefers to focus on identifying businesses that are “attractively valued and capable of delivering sustainable dividend growth in the years ahead”.
This focus allows for reinvested dividends, which he says have formed a “very significant” part of the long-term return delivered by equities.
Reinvested dividends provide a powerful boost to long-term equity total returns
Source: Morgan Stanley, Woodford IM
As the above chart shows, an investment of £1,000 in the FTSE All Share index in 1926 would have grown to a total return – i.e. with dividends reinvested – of £7.8m in 2017.
He said: “Over nine decades, an investor’s capital has appreciated at a compound annual growth rate of 5.4 per cent – this is an attractive growth rate in itself but, with dividends reinvested, the total return from UK equities compounds at an annual growth rate of 10.4 per cent.”
Woodford added: “Of course, part of this return can be explained by inflation and, at times, over the last 90 years there’s been a lot of inflation around.
“But that also highlights one of the other important things that makes equities, and the dividend in particular, special.”
He said: “Equities are real assets – they are stakes in real companies, operating in the real economy, which generate revenues, profits and cash flows that can rise with inflation.
“With those cash flows, companies pay their dividends which also tend to rise with inflation.
“Investing in equities therefore comes with an in-built inflation advantage which very few other asset classes can match. Cash and fixed-interest investments are nominal asset classes – they cannot protect an investor from the erosive impact of inflation.”
Since launch 2014, the £9.9bn CF Woodford Equity Income fund has delivered a total return of 33.48 per cent, compared with a gain of 20.28 per cent for the FTSE All Share index and a 20.13 per cent gain for the average IA UK Equity Income sector fund.
Last year the fund returned 3.019 per cent, compared with an 8.84 per cent gain for the average sector fund.
“Much of what we saw in 2016 does not appear to be grounded in fundamentals,” he noted. “In the long-run, fundamentals are all that matter for share prices, but over shorter periods, they can be overtaken by other drivers, such as sentiment and momentum.”
Fund vs sector & benchmark since launch
Source FE Analytics
However, despite describing the fund’s positioning last year as “unhelpful”, Woodford said he would not be changing his approach.
The fund has an ongoing charge fee (OCF) of 0.75 per cent as of 20 December 2016.