Digital disruption has been wreaking havoc across industries and now previous stalwarts of equity income portfolios such as tobacco, telecommunications and utilities companies are feeling the pinch. 
Long seen as sectors with predictable cash flow generation, protected by either regulation or dominant market positions, a number of these companies have unsustainably leveraged up their balance sheets to fund inorganic expansion.
At the same time, a cohort of agile companies is disrupting previously protected business models and pricing structures, meaning we can no longer rely on the old incumbents to provide sustainable dividends and capital appreciation.
Companies with the most to lose are those that have been slow to innovate and have relied on acquisitions to provide growth over the last decade, in some cases using cheap debt to fund empire building strategies. Vodafone, once a cornerstone of income funds, is a prime example of a business model under threat.
When investing over the medium-to-longer term, it is important to scrutinise the facts to limit the effect of behavioural biases.
So, what facts present themselves about Vodafone? The telecoms giant is entering a capital-intensive period as 5G is introduced across its network over the next three years. The capital costs to fund this upcoming roll-out combined with the recent acquisition of Liberty Global’s European operations for a total enterprise value of €18.4bn will stretch the company’s balance sheet to breaking point.
The company already has £64bn of debt and if organic growth remains elusive, the company will have limited strategic alternatives to service its debt pile. Recent action by the company’s management to cut the dividend will help the business, but investors should be under no illusion that this will be a one-off. Management teams tend to cut dividends when the writing is already on the wall.
So as the dividend aristocrats of the past such as Vodafone start to fade, where can investors look to for income in the future? We believe the answer lies in what we classify as ‘Global Leaders’ – businesses that can provide dividend growth and deliver a more consistent level of income and total return for long-term investors.
Such companies display five enduring but elusive characteristics.
First, they must have a robust balance sheet. Without this, a company cannot invest for growth and it cannot grow its dividend.
Second, it should have a durable and easily defined competitive advantage: what sets Global Leaders apart from their peers is the fact that their business models cannot be easily replicated.
Another key characteristic is their ability to grow consistently.
Fourth, and where our process departs from conventional income investing, is the need for a business to deliver high and consistent returns on capital invested. This demonstrates that a company is generating profitable growth.
Last, it is important that the business embraces a culture of innovation, an important quality which is often overlooked.
It is rare for a company to meet all five of these requirements but when they do, they present very compelling opportunities for income investors.
Using these characteristics as a template, we can make a meaningful comparison between Apple and Vodafone.
We believe Apple has entered the maturity phase of its business cycle. This is important because it leads to solid balance sheets, high cash generation and rapidly growing dividends. Apple defies the law of large numbers and continues to innovate and grow beyond expectations. It generates high and consistent returns on capital, something which is lacking with Vodafone.
Apple is a great example of a business that has hit the sweet spot of growth, solid balance sheet and low competitive threats, and which can consistently increase its dividend. Vodafone, on the other hand, has deteriorating metrics leading to a collapsing dividend.
Alphabet is another example of a company that has a competitive position that is hard to replicate.
It is plugged into the shift from high street to online shopping, currently at only 12 per cent penetration, and requires limited capital to maintain its core business. It has some $120bn sitting in cash on its balance sheet and is generating around $25bn of free cash flow every year.
As the company starts to transition from its lofty growth phase, we expect its management to initiate a dividend in the short to medium term. Alphabet already returns $10bn a year to shareholders via the more tax efficient method of share buybacks, but we expect it to align with Apple and initiate a dividend.
The outbreak of the Covid-19 this year and the resulting dividend drought has accelerated the trend which has seen the transfer of dividend-paying power from the staples of income portfolios to standout companies which embrace innovation and maintain a healthy balance sheet to drive future growth and dividend distributions.
This means income investors must view their universe through a different lens if they are to identify those businesses with the potential to deliver sustainable and growing dividends over the mid to long-term. While this lens puts Alphabet and Apple in a favourable light, Vodafone by comparison languishes in the shade.
Storm Uru is the manager of the Liontrust Global Dividend fund. The views expressed above are his own and should not be taken as investment advice.