Nick Kirrage, co-head of the Value team, and Sean Markowicz, part of the Research and Analytics team, chatted with us about the future of dividends and buybacks.
With so many investors reliant on dividends to boost their income or support their retirement we wanted know what's happening now, whether investors should be concerned and how the future of dividends might look.
Q1: UK newspaper The Times reported a few days ago that investors were facing about £600 million of cuts in dividends in the UK alone. It is a similar story across the world. Let’s start with the basics - what are dividends?
Nick Kirrage (NK): Dividends are the cashflows that a company elects to pay out to its shareholders as a reward for holding the shares over time. We hope that if they are good, growing businesses, companies can pay from their profits. They can also dispose of businesses that they own or raise debt to pay their dividend. When times are very good, there might be windfall profits and a lot to be paid out in dividends. When times are bad, there might not be, but a company might find other ways to keep its dividend going through the tough times until things get better.
At the moment, quite amazingly, there is a broad consensus from the vast bulk of companies that they are going to cut their dividends and hoard their cash. They want that security, and liquidity, which just means cash in the bank to give them options and security while things are tough.
Q2: Many businesses have been under pressure from regulators to cut their dividends. Usually companies would decided for themselves. Is regulators’ involvement unprecedented?
NK: We have seen this before in isolated ways, but this is quite different.
The regulators have stepped in. the UK banking regulator, for example, wants banks to suspend dividends for now. What’s more, there is moral uncertainty now for many UK companies. They will be using the government’s scheme to furlough staff, thereby taking money off the taxpayer, to avoid making people unemployed and to keep their businesses going. In these circumstances, why should businesses pay out to shareholders while they are being supported by the man and woman in the street?
It’s important to focus on whether the dividend is suspended for regulatory reasons or because business is uncertain. Is the business stopping its dividend because it does not have enough money to pay it? That could be the case for an airline, where business has dried up so the company is hoarding its cash?
Or is the dividend stopped because it is not seen as the right thing to do to pay it? The banking sector, for example, is well-capitalised, with as much security as it has had for 40 years but it is stopping dividend payments because it has been asked to do so by the regulator. Here, the dividend is simply deferred rather than, for certain businesses like high street retailers perhaps, destroyed for a period of time.
Q3: This leaves a huge hole in investors’ income, doesn’t it? For people in retirement, and those that use those dividends to top up their monthly income, that is going to be tough.
NK: That debate is yet to come. Right now, the average company sees no downside to cutting its dividend, and things are changing so quickly. It has become very consensual to cut the dividend. People will accept and understand it, so it seems reasonable. This means companies are cutting their dividends, whether or not they can pay them.
I think that the debate will move on to the second order effects. Although it seems like it is not impacting anyone, it is actually hitting a lot of people. The charity sector will be hit extraordinarily hard. The dividends received by charities support millions of pounds worth of charitable work, which is needed now more than ever as well as supporting employment within those charities. For charities and for retirees, the debate will move on to whether this is actually doing more harm than good. Should all companies cut dividends even if they don’t need to?
Q4: Two of the main ways to receive dividends are as cash or you can opt to reinvest. If you reinvest, you benefit from the effects of compounding, basically earning returns on returns. How does this work?
David Brett (DB): The effect of compounding can have a massive effect on investments themselves. For instance, the FTSE 100 Index only returned about 0.4% between 1999 and the end of 2019. But, if you include dividends, then that suddenly goes up to over 120%.
NK: It is extraordinarily difficult to replace dividends as they are a huge part of the returns over the long term. Reinvesting dividends means that they then earn money, then pay dividends and that then reinvests. This is called compounding and Albert Einstein described it as “the eighth wonder of the world”. It is how, if you invest early enough and for long enough, you can end up with a very significant pot. If you lose these dividends, even for a short period of time, it can have a dramatic impact on the returns that you make over the long term.
Q5: Why has a special form of a dividend called a share buyback become important and why are they controversial? Let’s start with the basics - what is a share buyback?
Sean Markowizc (SM): A share buyback involves a company buying back its own shares from the market place. This reduces the number of shares outstanding, boosting the company’s profits and its earnings per share (EPS). Typically, it also boosts the stock price as well. Buybacks are similar to dividends in that this is a way for companies to pay shareholders, but buybacks are much more flexible. They can be scrapped when cash preservation or creditworthiness are a priority. Dividends, meanwhile, are an ongoing commitment. Cutting them sends a bad signal about the company’s future profits so it is only done under exceptional circumstances.
Q6: There is a perception that buybacks have had a significant effect on stock market performance. Which sectors are likely to be affected and which sectors won’t have so much of a problem without buybacks?
SM: US corporates have been the single largest source of demand for US equities (shares) in recent years. Since 2008, they have spent around $ 4.5 trillion on net equity purchases, through a combination of buybacks and mergers and acquisitions of companies. This is around 50%more than they spent on dividends. This is why buybacks are often credited with fuelling the longest equity bull market in US history.
For the average US company, our research found that buybacks boosted EPS by only 1% per annum for the past five years. The annualised total return of the whole US equity market was 11% over the same period. So, despite all the hype about buybacks, they have been fairly insignificant for the average stock.
Sectors have differed, with consumer discretionary stocks (such as retail) and industrial stocks (such as transport) receiving the largest buyback boost leading to annual EPS growth of around 4.5% and 3.7% respectively.
A collapse in buybacks could potentially weigh heavily on their share prices. Ironically, these two sectors are more likely to cut buybacks given current travel restrictions and plummeting consumer demand. We found that buybacks had little impact on share prices in sectors perceived as more defensive, such as consumer staples (such as supermarkets) and healthcare.
Q7: Have shares in those companies that have performed more buybacks over the last few years been hit harder in the current downturn?
SM: If we look for companies with the highest buyback volume relating to their company’s size, the shares of the 100 companies with the highest buyback ratios have indeed outperformed the broader US stock market since 2008. However, in the first quarter of 2020, they tumbled by 31% compared with a fall of 21% for the overall US stock market – an underperformance of 10%. To that extent, there has been a correlation between companies that delivered higher returns through buybacks and those that are now underperforming.
Q8: Do we know what share of buybacks has come out of company profits and whether a company has taken out more debt to achieve buybacks? What is the outlook for buybacks now?
SM: Around 50% to 65% of buybacks have come out of companies’ reported profits, with about a third funded with debt in 2017. I think we could see a complete reversal in this trend with companies not only being forced to halt buybacks, but actually issue shares to pay down debt. At the moment, the most indebted companies are being forced to repair their balance sheets to avoid their credit rating being further downgraded. That could potentially act as a drag on their future earnings per share growth.
Q9: Where might that extra demand for equities come from to make up that lag caused by fewer share buybacks?
SM: That is indeed the big question – who is going to make up the demand? We know that exchange-traded funds, investment vehicles which passively track the market, were the second largest buyer of US shares after corporates.
It remains to be seen whether they will replace the demand from corporates. Corporates have not supported the US equity market to the same extent that people expected. For example, the top 20 companies in the US accounted for nearly a third of total buybacks over the last five years.
Apple alone accounted for 8%. As the downturn hits profits, I would expect more firms to suspend their buybacks.
However, the overall impact at the market level is going to be much more nuanced than widely believed. Nonetheless, there will be certain sectors where the impact will be more pronounced which is important for stock pickers to consider.
Q10: What is next for dividends after the virus? As an investor, income makes up a significant proportion of your returns, what would you be telling investors at this point?
NK: Long-term dividend growth does not always just go in one direction. The stock market has long periods with consistent gains and then there will be a very big setback. Historically, dividends have tended to be less volatile than the stock market itself. This is because businesses try and maintain dividends when times are tough, even if profits are under pressure.
This downturn is going to be different because so many businesses are having a dividend hiatus. There is an enormous concentration of dividends within the UK market. Of 700 or so UK companies, the top 10 pay 56% of all dividends and the top 20 pay 80% of all dividends. For Europe, the top 10 only pay 24% - less than half the UK figure. The effect of a market-wide dividend cut will be magnified in a very concentrated market. At this point in time, it is very difficult to know, but it is reasonable to expect that we might see a UK market dividend cut of 20% to 25% depending on how things develop.
Again, it is really important to note that many companies’ dividends are not going away because they cannot pay them. In the case of banks, or oil and gas, which represent a large part of the cuts, it is really just dividends deferred not destroyed. Dividend cuts from smaller and more directly-affected sectors by the virus, such as airlines, travel and leisure, high street retailers, are probably gone for a period of time. We will have to wait to see them return.
Q11: Thinking about the reason investors invest in specific shares in the first place, has something fundamentally changed?
NK: When investing in a company, investors are trying to construct a portfolio which does three things if you think about income. The first is: will it produce a decent dividend yield, the amount you are getting paid each year as a proportion of the amount that you invested?
Over time, you want that payout to grow so investors target dividend growth – the second leg. A growing business can pay out a bigger dividend in the future. Then the third leg, which is very important, is seeing capital growth, which needs to compound.
I always think of this as a stool with three legs - if any one of the legs is too short, then the stool falls over.
In the short term, investors might have businesses that are cutting their dividend but they might not sell them because they think that their long-term prospects are good. Investors should really think about the long-term prospects.
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