Unprecedented. That is the only word to describe the ongoing collapse of corporate dividends. At the time of writing, FTSE 100 dividend futures are pricing a 62 per cent reduction in dividends this year. This compares to a peak drop of 20 per cent globally in the ‘great financial crisis’ just over a decade ago. 
There will be a great temptation in the weeks and months ahead for dividend investors to trade into high-yielding stocks to ‘plug the income gap’. Wherever a company has withdrawn its dividend and there is a hole in the investor’s income stream, there will be an impulse to sell that company and reinvest the capital into another high-yielder, whether that be an oil company, a retailer, a tobacco company or a REIT, most of which now trade on high dividend yields.
In our view, this is a mug’s game. Many of these seemingly high-yield dividends will prove to be a mirage. In the current environment there is unprecedented uncertainty about which companies will pay their dividends and which will not. Selling a dividend-cutter to buy a company which subsequently reduces its dividend will simply incur trading costs.
There is also a high risk that trying to plug the income gap will end up destroying capital value. Why? Because earnings and dividends ultimately determine capital value, and many high-yielding companies suffering large drops in earnings and dividends will simply not see a bounce-back to the levels they enjoyed before the coronavirus struck. For many such companies we anticipate a permanent impairment of their dividend-paying ability.
What about the less cyclical high-yielding sectors that income investors have traditionally turned to, such as utilities, tobacco, and telecoms companies? Unfortunately, these are mature sectors, fraught with regulatory risk, and with weak long-term growth prospects. It is not a coincidence that many companies in these ‘low-risk’ sectors, from Vodafone to Centrica, have failed to deliver profit growth over long periods – and in many cases have had to rebase their dividends.
Now for the good news. The beauty of equity markets is that, as an active investor, you can avoid the companies and business models of yesterday and invest instead in the shares of the future. That may limit your dividend income in 2020, as these companies have a lower yield than others which are ex-growth. But in the long-term, if you find these companies, it is likely to pay off in far higher levels of income, together with strong capital appreciation.
For every company facing a prolonged period of troubled times, there is another for which Covid-19 will ultimately prove transitory. Great companies with relevant business models will undoubtedly see earnings and dividends bounce back.
Well-run insurance companies, for instance, will continue to play a vital role in protecting policyholders against disasters – and the value of that insurance may well be higher in a post-pandemic world. Innovative manufacturing companies, with products that genuinely enhance the efficiency of their customers, will see their earnings bounce back too.
Delivery companies will find their services in ever-greater demand. Restaurants which are happy to deliver as well as host diners will surely thrive. Even in the property sector dividend investors can anticipate that well-invested residential assets, in a post-virus world of Zooming and flexible home-working, will generate solid rental income.
The challenge is to exercise the discipline to invest in these businesses of the future, rather than clinging to the high-yielders of the past. Even if doing so means moderating dividend income in the short term.
The question for dividend investors to ask therefore is not “What companies can I buy to plug this year’s income gap?” It is rather: “What companies do I believe have a strong future once this crisis has passed?”
Investors should sacrifice short-term yield in the pursuit of better long-term income and capital growth. Shunning many of the sectors and companies that are now struggling profoundly in favour of longer-term growth prospects has delivered stronger total returns than most short-term yield-focused funds, as well as providing an income which has risen over time.
Companies that can grow their earnings to support higher dividends in five or 10 years’ time are far more rewarding investments than short-term ‘yield plays’. We largely avoid the mature, ex-growth companies that have propped up the market’s yield.
In assessing dividend resilience, aim to avoid companies that are capital-intensive, or highly cyclical, or are simply distributing cash in a way that is not in the long-term interests of their business. A checklist for dividend dependability should penalise companies for these and other weaknesses. Discipline in observing these risks, focusing instead on companies with stable, cash-generative business models, can greatly enhance long-term income and capital prospects.
James Dow is co-manager of the Scottish American Investment Company and co-head of the global income growth team at Baillie Gifford. The views expressed above are his own and should not be taken as investment advice.