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Why the ‘hunt for yield’ could be crippling the UK’s largest dividend payers

Analysts and managers weigh in on whether companies are paying too much to investors in the form of dividends and not enough on R&D.

Jonathan Jones

By Jonathan Jones, Reporter, FE Trustnet
Thursday August 10, 2017

Dividends are a key component of long-term investment returns but the market has become too quick to judge those that decide not to pay them, according to several industry commentators.

The low growth environment experienced since the financial crisis has placed an additional emphasis on companies with the ability to pay out attractive dividends.

With UK 10-year government bonds offering a yield of a little more than 1 per cent, the FTSE All Share yield of almost 4 per cent looks extremely attractive.

As the below chart shows, regular dividends paid out hit record highs last year and are expected to repeat the feat again this year.

Dividends paid out over 10yrs


Source: Capita Dividend Monitor

But some commentators have become concerned that this is at the detriment of companies investing in organic growth.

David Smith, fund manager of the Henderson High Income trust, said: “When management teams talk about capital allocation they have got to balance that cashflow well.

“As shareholders we provide capital to management teams and we expect some form of payment, i.e. via dividend, but I think there is a fine line between not over distributing and making sure you are still investing the business to be able to grow in the longer term.”

Jason Hollands, managing director at Tilney Group, said: “It is often observed that companies that pay high dividends are good companies to invest in but I think someone like [fund manager] Terry Smith would argue that that is only part of the picture.

“Companies could be generating lots of cash and actually reinvesting it within the business and compounding growth in a very efficient way rather than paying it all out.

“In the UK there is a strong history of dividend payouts but last year 89 per cent of earnings from UK-listed companies were paid out as dividends,” he noted.

“I think that is pretty much a record high and that is not healthy in many ways because it shows you that a lot of these businesses are acting like ATM machines and just chucking out everything they can to shareholders because perhaps they can’t find the right opportunities to reinvest in themselves to keep growing.

“Whereas [someone like Smith] would argue that really good companies have that confidence in their business to perhaps make some payouts but also to reinvest in the business where they can very efficiently.”

When companies to decide to cut their dividend in an effort to stimulate growth or as part of a turnaround strategy, however, the market can be too quick to punish it, according to Schroder’s value equities team fund manager Simon Adler.

He said Pearson is an example of this, having sold off its 22 per cent stake in Penguin Random House earlier this year to streamline the business as the world’s leading educational publisher.

“The sale, alongside a recapitalisation of the business, raised some $1bn [£767m] and was initially welcomed by the markets. Yet, Pearson’s share price ended the day down,” Adler said.

While the manager said “investors should avoid trying to pinpoint the reasons why share prices rise and fall,” the general consensus for the share price fall appears to be due to it reviewing its dividend policy.

Indeed, Pearson announced at the same time that it would pay out a lower dividend than the market had been expecting.

Performance of Pearson YTD


Source: FE Analytics

As the above chart shows, the January announcement hit the share price, which initially plummeted 30 per cent. Year-to-date it remains 19.37 per cent lower than at the end of 2016.

“Regardless of whether that provoked the drop in Pearson’s share price, it does offer a useful opportunity to assert that we would never tell a company what its dividend should or should not be,” he said.

“There is no doubt that dividends are an important component of long-term investment returns – but the key phrase there is ‘long term’.

“If it is better for a business to cut its dividend in the short term in order to protect its balance sheet or allow it to invest more money and so turn it round to be the kind of business we would want to invest in, then we are very comfortable with that.”

Adler explained: “Far better it take that approach than overstretch its balance sheet to pay a dividend it cannot afford.

“That, incidentally, is a situation in which many of the high-paying so-called ‘bond proxy’ businesses are in increasing danger of finding themselves. Currently terrified of what disappointed investors could do to their share price if they cut their dividends.”

It is this shift in sentiment from reinvesting capital to paying out dividends and the unwillingness to change for fear of the market’s reaction that has convinced IBOSS’s Chris Metcalfe to sell his UK equity income exposure.

“On the individual dividend payers, I suppose people are under pressure to return money to shareholders or pay it out in dividends,” said Metcalfe.

The manager added that this is not just a UK phenomenon however, with companies in the US using share buybacks to inflate share prices instead of investing in research and development.

“You’d hope that the people running the company would know what they really need to spend but I suppose this comes down to the short-termism that it is all about hitting your next quarter or you next half. Or if you are looking a really long way out then the next year.”

“We moved away from the big traditional UK equity income funds quite a while ago on these sort of concerns. I think there is always a danger when people are chasing yield,” he noted.

“The equity income funds are all holding pretty much the same assets so there’s a lot of false diversification.”

However, there is one equity income fund that he is invested in: Man GLG UK Income, managed by FE Alpha Manager Henry Dixon.

Performance of fund vs sector and benchmark YTD


Source: FE Analytics

The four crown-rated fund has been the best performing fund in the IA UK Equity Income sector so far this year, returning 19.92 per cent, having been in the bottom quartile last year.

It is 40.49 percentage points underweight to mega caps compared to the FTSE All Share, with just 25.58 per cent of the portfolio invested in market cap range. It has 28.99 per cent invested in small caps and 32.98 per cent in the FTSE 250.

The fund is currently yielding 4.22 per cent and has a clean ongoing charges figure (OCF) of 0.9 per cent.

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Funds mentioned in this article

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Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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