UK banks won’t fully restore their dividends until 2022, but this doesn’t mean there isn’t value to be found in the sector, according to Simon Gergel of the Merchants Trust.
The latest Link Group Dividend Monitor, released today, showed a 49.1 per cent drop in headline dividends in the UK in Q3, but said “the worst is over”.
However, while Gergel (pictured) agreed we have already seen the “sharpest” dividend cuts, he warned it is unlikely there will be a full recovery by next year.
“In the last few weeks, we have certainly seen more positive comments from companies about when they might start paying dividends again,” he said.
“I think in a year's time there won't be that many companies paying absolute zero. But there will still be a few that have fairly token dividends. The final thing to add to that, because it is a complicated picture, is not every company will go back to paying the dividends they paid before.
“Our outlook is that you'll see the sharpest dividend cuts this year, a partial recovery next year, and a much better and much fuller recovery in year three.”
Gergel pointed to the banks as a good example of a sector where the dividend recovery will be delayed.
The FTSE 350 Banks index is down by 49.18 per cent this year. Aside from the recessionary backdrop and rock-bottom interest rates, the sector was also hit by the decision to halt dividend payments and share buybacks at the end of March, following discussions with the Bank of England.
Performance of index in 2020
Source: FE Analytics
But Gergel said that when you take these headwinds into account, it has held up relatively well.
“What has been interesting in the last few weeks is you have started to see mortgage spreads go up despite interest rates coming down,” the manager noted.
“Banks are seeing quite strong demand for mortgages and they are pushing their prices up. What is important for banks is not just where interest rates are, but also the spread they can charge when they lend money out. So there are things they can do to offset some of the pressures.”
But he admitted this doesn’t disguise the fact that the sector faces an uphill struggle – not least with the Bank of England raising the prospect of negative interest rates.
“It's one of the reasons why we're not expecting banks’ return on capital to get back anywhere near to the 10 per cent level that historically they have been targeting,” he added.
“We're looking at many of the big banks with a return on capital of probably 7 or 8 per cent.”
Yet despite the problems faced by the banks, Gergel said they could still be decent investments.
For example, he currently holds Barclays which is trading at around 0.3x book value, a fairly typical figure for the sector. The manager said that at this level, it is pricing in a return on capital well below the pessimistic scenario outlined above.
And Gergel said it is also worth noting that the banks are in a much stronger position now than they were in the last cycle, holding higher levels of capital and operating within more stringent regulations.
“There's an accounting standard IFRS 9, which means banks have to take provisions early on in the cycle for the bad debts they expect to have,” he noted.
“This is very different to what they've done before. The banks have already provided a lot of money in accounting terms for the bad debts they anticipate, which means as and when those bad debts come through, and when the economy recovers, the future bad debt experience won't be as bad as it normally is and the banks could recover quite quickly.”
He added: “It's an interesting sector. It's a bit of a dilemma, because clearly it is economically sensitive. But the banks are trading at levels similar to where they were in the financial crisis and yet their balance sheets are much stronger and, if anything, the economy is actually doing better than it was at that point.
“Our assessment is you get a big dividend cut in the market this year, there will be a big recovery next year, and another quite big recovery in the following year.”
Data from FE Analytics shows Merchants Trust has made 60.8 per cent over the past decade, compared with 71.2 per cent from the IT UK Equity Income sector and 60.49 per cent from the FTSE All Share.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
Merchants Trust is on a discount to net asset value (NAV) of 5.76 per cent compared with 1.89 and 0.23 per cent from its one- and three-year averages.
It is yielding 7.64 per cent and has increased its dividend in every one of the past 38 years.
The trust has ongoing charges of 0.56 per cent and is 24 per cent geared.