Commentators have made much of recent articles suggesting that the UK equity market is akin to Jurassic Park and that income investing is a factor in its travails.
As a UK equity income manager of four decades’ standing, I might be assumed to be a vexed T. rex, yet I have sympathy with parts of the argument. When a market like the FTSE All Share lags the MSCI All Country World Index by nearly 40percentage points over five years – and more over 10 – it is clear that all is not well and some things need fixing.
It is claimed that the UK is living in a bygone era where companies have been encouraged to prioritise dividends over investment. In an age of disruption and fast-moving change, say critics, these businesses have effectively driven themselves down a cul-de-sac – and you can’t get very far down one of those (or go very fast).
Dividend investors not opposed to investment
However, there is no reason why paying a good and growing dividend and investing appropriately should be mutually exclusive. Dividend growth will be short-lived without adequate investment, and the dividend itself may ultimately be jeopardised as well.
Many so-called dividend stocks comfortably manage the trinity of investing, paying dividends and having surplus cash flow thereafter. Plenty of the acknowledged US growth stocks have accomplished this, too – although a meaningful portion of the cash flow has been returned via share buybacks, which don’t come with the same embedded promise as a dividend policy but nevertheless signal that the company is generating resources beyond its investment needs.
We are seeing the same in the UK today – companies with attractive dividends buying back shares. One has to think that they wouldn’t be doing that if the money was needed for investment.
It makes no sense for the Artemis Income team, as investors with an average holding period of more than six years, to be anything other than supportive of a strategy that promotes and prolongs the profile of cash generation and therefore dividend capacity.
Similarly, we are even-handed in judging whether dividends or share buybacks are the best route to returning surplus capital. When a company requires investment at the expense of dividends – and when the case is a strong one – shareholders should be delighted, as this should lead to better cash flows and dividends in the future.
Are dividends so bad?
At the time of writing, the sleigh ride of a number of iconic US ‘growth’ stocks has come to a shuddering halt. Some have dived 50% or more. No doubt shareholders, in light of underperformance, will be scrutinising the absence of any meaningful cash flow and questioning the return on capital invested.
In our experience, analysing the path and progression of cash flows brings more rigour to the decision to invest shareholders’ capital. It means we look beyond the shorter term and investable fluctuations in company performance.
Although in many people’s minds the idea of a company investing conjures up images of new factories and machines, in today’s world investment is much more likely to involve people, talent, software systems and marketing. These items are expensed through the annual profit and loss account.
As a result, any increase in ‘investment’ leads to a lower annual profit. This prompts some in the investment community to associate this investment with a ‘downgrade’ or ‘profit warning’ and, in turn, often leaves the share price at the mercy of shorter-term money, momentum funds or quant traders – call them what you will.
By contrast, a long-term investor has the time horizon and patience to look beyond this ‘noise’ and reap the benefits.
So what’s the problem?
I am not convinced that the UK equity market will, without help or change, entirely escape the perceptions that have clung to it in recent years and make up the distance on other markets. There is even one industry that is hoping that it retains its cheap and unloved status – private equity.
Last year private equity managers hand-sanitised their shopping trolleys and sped down the deserted aisles of the UK equity market, picking up £55bn of companies supposedly past their sell-by date.
Madness? Misplaced optimism? Private equity hasn’t got to be a significant part of pension fund and endowment assets by being dumb. Perhaps the UK equity market can learn from private equity – imitation might be the sincerest form of profitability. Three areas warrant investigation.
Risk: CD&R paid a premium for Morrisons, so what magic extra ingredient – beyond competent management and strategy – will create value from here?
The answer is debt – and lots of it. This can amplify returns if successfully applied. Is the adventurous capital structure of private equity a problem here or is it the caution of investors in listed markets? Perhaps both.
Understandably and rightly, companies have adopted a cautious stance during the pandemic, but from here maybe companies on listed markets are being too conservative in their use of cheap credit because investors frown on it so much.
Managers should be encouraged to run with appropriate leverage, not to get cowed into balance-sheet strength that makes them a gift for private equity managers.
Reporting: The UK’s detractors often accuse the investor community of spending more time prosecuting the present – poring over quarterly figures and trading statements – than envisaging the future.
One chief executive, having recently gone over to private equity, said she had spent some 20-30% of her time in her old role reporting and answering to shareholders.
Too often executives find their priorities derailed by having to respond to the news agenda to support the share price. This reduces their bandwidth and latitude to envisage and shape the future themselves.
With only a few shareholders to report to, managers in the private equity arena are free to pay maximum attention to the business and have more time to focus on building value. Perhaps it would help managers of listed companies if quarterly reporting rules were scrapped. Twice a year should suffice.
Remuneration: Another advantage that private equity has is around remuneration. Some of our most successful investments within the Artemis Income Fund have been in companies whose executives, though remunerated well in absolute terms and relative to other managers in the UK, have been paid far less than they would earn in private equity – or in the US. Often shareholders have resisted plans to remedy this.
It seems contradictory for investors to demand that UK companies perform like their US counterparts but then to risk talented managers migrating across the Atlantic or to the offices of private equity because they won’t pay them enough.
While being wary of remuneration packages that reward failure, more needs to be done to incentivise and recognise success if UK listed companies are to attract and retain the best management teams.
Working together
Everyone knows the UK is markedly undervalued. It is time UK companies, fund managers and policymakers looked at what can be learnt from others to make investing in the UK market an altogether more enticing proposition – a Disney EPCOT Center rather than a Jurassic Park.
Adrian Frost is co-manager of the Artemis Income fund. The views expressed above are his own and should not be taken as investment advice.