Dividend-paying stocks have been highly sought-after since the global financial crisis of 2008 as the low interest rate environment has forced risk-averse investors to look elsewhere for steady income streams.
While dividends are a mainstay in the UK market, in the US the practice is much less common with company profits either ploughed into share buybacks or used to fund merger & acquisition (M&A) activity.
Below FE Trustnet asks several experts why there is a greater focus on growth in the US while in the UK there is more emphasis placed on income.
Starting with the UK, FE Alpha Manager Siddarth Chand Lall, manager of the Marlborough Multi Cap Income fund, said there are a number of reasons investors look to income.
While the most obvious answer is that it is for investors in retirement looking to live off an income, he said that those being forced up the risk curve can also see dividends as a gauge of security in a company.
“I think it gives you reliability and some cashflow discipline at the same time but also it can be seen as a business confidence signal,” said Chand Lall.
“A company that is perhaps trading in-line [with expectations] but growing its dividends nicely wouldn’t necessarily be doing that if it was worried about the next six months or a year.
“If it is anticipating a downgrade of any significance you would see that it is slowing down its dividend distributions because it needs to conserve capital.”
Source: FE Analytics
The Marlborough Multi Cap Income fund manager said a recent example is HSBC, which made very little mention its dividend in its annual results. Chand Lall said instead, the firm is focused on bolstering its cash position.
“So, you could see that their business signal was that they needed to wait and have a bit of caution,” he added.
Conversely, Lloyds Bank, which also released its results around the same time, announced that it is to hike its dividend by 20 per cent. The firm also announced a buyback programme worth an extra £1bn.
Paying out dividends can also be a measure that companies are not misusing excess capital as if there are no new opportunities it is better to pay out income and wait for the next business cycle, Chand Lall said.
“Take the UK housebuilders as an example. They are not buying lots of land that they do nothing with and as a result they are able to pay a higher dividend,” Chand Lall added.
While the UK has a strong dividend culture, other markets place less emphasis on dividends, with the US the most notable example.
“I think it is just cultural that in the US they prioritise growth over income and investors want companies that grow their earnings per share,” said Mark Sherlock, manager of the Hermes US SMID Equity fund.
As well as this, Sherlock said management teams haven’t necessarily been rewarded for paying out big dividends.
“I think in aggregate they would possibly see it as a suggestion that they haven’t got enough to invest in and what better to invest in than your own business – i.e. by doing buybacks,” he explained.
Foreign & Colonial Investment Trust manager Paul Niven agreed, noting that earnings per share (EPS) has become a key metric for investors and management teams alike.
“There isn’t a lot of evidence of shareholders rewarding companies for distributing profits in the form of dividends,” said Niven.
“A lot of option packages and incentive structures for US executives and maybe more globally as well now are related to EPS targets and the truest way to enhance EPS other than cutting costs is to buy back shares.”
The Foreign & Colonial manager added that it also has to do with the make-up of the US market, which includes more typically high-growth sectors such as technology and biotechnology, and fewer ex-growth sectors such as utilities.
Sector composition of S&P 500
Source: S&P Dow Jones Indices
Indeed, the UK’s FTSE All Share has just a 1.1 per cent weighting to technology but a 25.8 per cent weighting to financials, 24.2 per cent of the S&P 500 is made up of technology stocks, as the above chart shows.
“People will look to the US market and say it is a low yielder at 2 per cent but that is partly because it has a high proportion of very low or zero-yielding stocks in dividend terms,” he said.
“That comes back to this point about the preponderance of growth stocks in the US and the fact it has a large amount of stocks which choose to reinvest and not to distribute that profit to shareholders,” said Foreign & Colonial manager Niven.
“They think shareholders are better served by buying back shares to boost stock price or buying up other businesses.”
Marlborough’s Chand Lall agreed, saying that there is more of an M&A culture in the US than there is in the UK.
Indeed, the number of mergers & acquisitions reached a record level last year, as the below chart shows, although the value of these deals fell from the previous year’s record highs.
Source: Institute for Mergers, Acquisitions and Alliances
“In a more aggressive M&A market you are unlikely to be increasing dividends, paying special dividends and buying businesses unless your operating model is so lean that you don’t need much capex [capital expenditure] and it takes care of itself,” he said.
While income is important however, Foreign & Colonial manager Niven said investors should not sacrifice capital in pursuit of income.
“You can buy high yielding shares, sectors or markets but it doesn’t necessarily equate to an attractive total return,” he warned.
“I know the long-term observation in terms of the proportion of equities returns that come from dividends and so on but simply chasing income for its own sake is not necessarily an appropriate strategy in our view.
“Often high-yielding shares are signalling low-growth prospects or some financials issues that the company might be facing which means it is lowly rated and the dividends high.