The unprecedented market conditions during the past month caused by coronavirus have seen many companies cut their dividends in the face of more uncertainty.
Indeed, a number of the UK market’s best-known dividend payers have been among those cutting their payouts over the past month, with Investec’s Alan Brierley and Ben Newell suggesting that markets are currently pricing in a fall in dividend of around 30 per cent.
As such, investors might want to consider closed-ended UK equity income strategies that can demonstrate “an outstanding long-term record of progressive dividends”.
“Unlike open-ended funds, where distributions are directly linked to underlying revenue, the ability to retain surplus income and smooth dividends in challenging conditions is a critical competitive advantage,” said the analysts.
“In the immediate aftermath of the 2008 financial crisis, despite sharp falls in income, 11 out of 14 UK equity income investment companies still increased dividends, while the only dividend cut was one of 7 per cent.”
JP Morgan Claverhouse increased its dividend the most during the crisis, hiking it by 7 per cent despite a 36 per cent fall in earnings per share.
Two froze payouts – Lowland for one year and Dunedin Income Growth for two years – while Nick Train’s Finsbury Growth & Income trust was the only dividend cut.
They added: “No two crises are the same, but we take some comfort from this experience.”
Source: Investec
In recent years, said Brierley and Newell, trusts have been building up reserves although the “rainy day” has now arrived.
The ability to retain income has become a critical competitive advantage that the closed-ended strategies have over their open-ended peers that must distribute all income.
“By retaining income during more buoyant years, closed-end funds are able to build up revenue reserves, which can then be used to meet revenue shortfalls and so ‘smooth out’ dividends in more challenging conditions,” said the Investec analysts.
“In addition, investment companies are able to pay dividends out of capital.”
As such, those with the greatest revenue reserves might be better placed currently to maintain dividend payments as UK companies cut or postpone dividends.
Source: Investec
Below, the Investec analysts consider what impact a 30 per cent fall in income – greater than that experienced during the financial crisis – could have on equity income trust reserves.
In addition, the analysts have assumed that trusts continue delivering progressive dividend growth of 3 per cent.
“Just a few weeks ago, to talk about a 30 per cent cut in dividends would have sounded nonsensical,” they said. “However, the world has now changed.
“We hope that a 30 per cent reduction in income will ultimately prove to be too severe, but in reality we are now operating in an information vacuum, with little or no visibility on the outlook for the global economy and/or dividends.”
In its first scenario, a brutal few months is followed by a strong economic recovery fuelled by unprecedented liquidity and Covid-19 brought under control.
“The end of Year One would be the nadir, with dividends then returning to pre-crisis levels,” they said. “Only time will tell whether the economy will ‘skyrocket’, as forecast by president Donald Trump, but there are obvious risks here.”
In such a scenario, all UK income trusts would be able to cover any such shortfall in income and in most cases the revenue reserve would remain healthy, although dividends would be uncovered.
Source: Investec
The pair also decided to find out what would happen if there were a second year where dividends were cut by 30 per cent.
Under such circumstances, they noted, a further 3 per cent increase in the payout would be a tough call for any board.
Source: Investec
“In this theoretical scenario, the revenue reserves of eight companies would still be sufficient to cover the resultant shortfall although they would be left rather threadbare,” said Brierley and Newell. “However, for the remaining companies, the revenue reserves would not be sufficient.”