Could investors find themselves caught in ‘dividend traps’ amid falling profits?

The impact of Covid-19 on profits could leave some investors stranded in so-called ‘dividend traps’, according to Janus Henderson Global Investors, as many companies have already been forced to cut dividends.

While cuts are nothing new, in a normal recession companies would utilise their dividend cover and dividends would reduce much less than profits to protect the income of its shareholders.

Investors often look for companies where dividends are comfortably covered by profits and the cover ratio is one indicator of how comfortable that is, looking at the value of profits divided by the value of dividends.

However, this recession is unique in that it has hit every sector in every region. 

Below, Ben Lofthouse, manager of the Henderson International Income Trust (pictured), presents the findings of the Janus Henderson’s Global Dividend Cover Report and outlines the importance of looking at the dividend cover for investors and the perils of being left in the ‘dividend trap’.

Global profits rose 1.1 per cent to £2.17trn in 2019, the slowest rate of growth since 2015, due to subdued global economy and rising trade tensions. Nevertheless, higher profits meant greater payouts as the world’s top 1,200 companies paying out just over £1trn, an 8.8 per cent rise on the previous year.

However, the Covid-19 pandemic has had a severe impact on profits as economies have locked down to control the spread of the virus.

Over the next year, consensus estimates imply that global profits will fall to £1.7trn, down by over a fifth (22 per cent).

Many companies have already started to cut dividends and many more may not be able to cover existing payouts.

Global dividends of top 1,200 companies

Source: Henderson International Income Trust (as of June 2020)

As the chart shows, dividends are expected to fall sharply in 2020, even in a best-case scenario.

In the most recent Janus Henderson Global Dividend Index, dividends were forecast to decline by between 15 per cent and 34 per cent this year, more than they did during the global financial crisis.

And when dividends rise quicker than profits, the dividend cover falls.

Last year saw a continuation of a downward trend in dividend cover that has been in effect since the post-financial crash highs of 2010.

“The yearly decline in 2019 dividend cover is part of the long-term trend that has seen dividend cover fall in every region of the world and every industry as the economic cycle has matured,” said analysts.

“The decline in dividends looks set to be similar or worse than the decline in profits, meaning that companies are protecting their balance sheets to see them through the crisis. This will allow them to emerge stronger,” Lofthouse said.

During a recession, company balance sheets can be stretched to accommodate distributions to shareholders when profits are hit. These reserves can be supplemented during the recovery when profit returns to previous levels.

Thereafter, dividend cover usually drops to a low level during a recession before bouncing back strongly to a high level soon after a downturn.

Dividend cover by region

Source: Henderson International Income Trust, June 2020

While the UK and Australia have a long history of paying unsustainably high dividends, in parts of Asia and Japan where it’s relatively new, dividend growth can exceed profit growth for a considerable period until high dividend cover comes into line with norms elsewhere. This would explain that over the last 10 years, dividends have more than tripled in Asia, Japan and the emerging markets, while profits are still yet to double.

Nevertheless, Janus Henderson claimed that more than one-fifth (£230bn) of the world’s dividends are vulnerable to a cut, and that half the highest yielding companies in the world were so-called dividend traps.

A dividend trap, the asset manager explained, is when a stock’s yield is just too good to be true compared to similar companies. These traps, according to Janus Henderson research, are twice as likely to cut the dividend and have dividend cover that’s half as good as the global average.

If the income an investor had expected is cut or has no prospect of growth, this eliminates one of the main advantages in investing in equities.

Janus Henderson analysts outline that while high yields are temping, they can be dangerous.

For instance, Royal Dutch Shell, in 2019 shares yielded more than 3x the global average and it was the biggest dividend payer in the world.

The oil giant only just made enough profit that year, so during the oil price war in early 2020, it was making a loss on the oil it produced prior to the Covid-19 pandemic.

Royal Dutch Shell has now cut its dividend by two thirds, as it is unsustainable to have the previous amounts of cash outflow every year.

Their research showed that by late May, 21 per cent of companies in their index had cut dividends for 2020.

“Companies distributing excessively high dividends may be able to sustain large payouts during the good times, but as soon as a crisis like 2020’s hits, dividend cuts become unavoidable un order to protect the business through the downturn,” analysts commented.

The companies identified as dividend traps had an average dividend cover last year of 1.2x, much less than the 2.1x for the wider global market.

“Investors should remember that a temporary halt in dividends does not change the fundamental value of a company – that is driven more by the ability of the company to flourish and grow over the longer term,” the fund manager said.

“Diversification is an effective way to reduce risk and provide a balanced income from companies all round the world – this is the very reason HINT exists.”

Performance of trust vs sector & benchmark over 3yrs

Source: FE Analytics

HINT has returned 7.13 per cent, whereas its benchmark, the MSCI World index returned 32.15 per cent.