When dividends are cut

Last week, HSBC suspended its dividend for the first time since the Second World War. It has since been joined in halting pay-outs to shareholders by 23 other FTSE 100 companies, including all of the other banks, Rolls Royce, WPP and ITV. The same is happening across Europe and the US.

Coronavirus has forced us all to change our behaviours. Life is very different to how it looked just a few months ago. We’re all doing things differently, whether it’s due to our collective consciences, government-imposed restrictions, changing social norms or a blend of all three.

Across the globe, companies are also changing their behaviour dramatically. Dividends are the most sensitive and obvious example as COVID-19 continues to disrupt and distort the status quo.

Economically, dividend cuts make sense. Equity investors share in the fortunes of a business, good or bad. So in a good year, if a company makes a decent profit and doesn’t see the need to reinvest all the proceeds in the business, paying it back to the shareholders – the owners – is often the right thing to do.

And the inverse also holds true. If a company believes it may require the cash to stabilise the business through a tough time, shareholders should respect that – their investment is being protected for the long term by the people running the business. No one is automatically entitled to a dividend.

That’s the theory. The reality is that investors come to expect dividend payments from businesses, indeed many rely on dividends for income (next week Matt Yeates will be telling you how 7IM can help avoid such issues). The financial industry doesn’t help – putting together funds and indices composed of companies who are ‘reliable’ dividend payers, which isn’t the same as ‘guaranteed’. The low interest rate world has made the problem even worse, as investors have replaced low-yielding bonds with high-dividend paying equities in the process moving from low-risk assets to high-risk assets, sometimes without even noticing.

COVID-19 has hit dividends hard. Some companies are looking at a rough next few months, and boards have decided that in the short term cash would be more useful in the business than in the shareholders’ pockets. Other companies are being forced to cut dividends if they want assistance from the government. In Europe, specific restrictions have been placed on companies listed in France or Germany. Globally we are seeing restrictions on banks, who are still paying for the sins of the last crisis. The loans and grants available come with explicit restrictions on how they are to be used; for protecting workers, not rewarding shareholders.

Still, other companies are watching the way the wind is blowing – even if they are in good shape. Why risk the bad press from not cutting dividends? Cut this year, be a good corporate citizen, and then get the shareholders back on side over the next twelve months with promises of special payments in the future.

All of this disruption has caused extreme stress in the European dividend futures markets, where you can buy and sell the stream of dividend payments for any given year. Given recent announcements, the stream of payments in 2020 is going to be a lot lower than expected a month or so ago. Looking to 2021, the economic disruption is likely to mean lower earnings, even if companies want to start paying out again. The prices of these instruments have fallen by 50% since the start of this year – for good reason – and those announcements are not going to be unwound in the near term. However, the value for the 2022 and 2023 payment streams have fallen by similar amounts.

At 7IM we’ve had European dividends in and out of portfolios since 2012. We’ve become familiar with the market, adding positions when they seem cheap and taking profits once the value is realised. This has been another opportunity so we’ve bought 2022 and 2023 maturity dividends, at what we believe are significant discounts.

By the end of 2022 we believe that Europe’s companies are going to be earning money again and looking to return to normal, enticing shareholders with dividend payments. The current entry price also builds in a decent margin of error – even if European businesses only pay what they paid at the depths of the Global Financial Crisis in 2008, our return will still be mildly positive. The position is around 2% of a Balanced portfolio, in line with our careful management of risk exposures.