The legal relationship between the joint stock company and its shareholders deems that the only thing to which an equity investor is entitled is the dividend that a board of directors sees fit to declare. An equity investor in today’s environment is likely to be experiencing the immediate pain of dividend cuts or cancellations. This requires the equity holder to revisit the investment thesis – a task made more challenging by the lack of comparative periods on which to draw reference.
While some businesses are able to continue to operate with modest levels of disruption in the current environment, others have experienced a complete halt in operational activities and attendant revenues. These companies must prioritise near term survival in capital allocation decisions. To be clear, the declaration of a dividend is a capital allocation decision. It matters not that a particular company has a long and aristocratic history of dividend payments. Each year, management must determine whether to retain all profits or whether to take a portion of profits that could be retained and spoon them into the begging bowls of shareholders. Readers of Dickens might compare some shareholders with Oliver Twist.
The UK has one of the strongest dividend cultures across global equity markets and it is here we will witness deep cuts. Dividend futures markets are pricing a 55% decline in the value of dividend payments from the FTSE 100 cohort of companies in 2020. The yield of 6% that looked appealing to some at the start of the year will soon reduce to 2.8%.
We have already witnessed the cut which was perhaps the most anticipated; Royal Dutch Shell. Shell has a gold-plated dividend track record going back to the Second World War. This had perhaps become a millstone around the board’s neck. Oil sector specialists have long questioned the size of Shell’s pay-out and the current environment of economic slowdown along with a sharp decline in the oil price comes at a time when Shell must invest heavily in the transition away from carbon fuels. The 66% reduction in dividend may turn out to be generous. The stated rationale for the cut was to improve balance sheet strength and this should be lauded. Indeed, balance sheet is the nub of the issue.
For companies to prosper in the long term, they must be able to weather the current period of reduced economic activity and emerge on the other side in a position to take advantage of opportunity. Simply put, a business with a balance sheet groaning under the weight of debt is beholden to those debtholders and banks. It is inherently less fleet of foot than the business which has prudently maintained manageable, modest or even zero gearing. A balance sheet dominated by equity with the equity holders eager to see improved Return on Invested Capital will support a company eager to invest in long term projects, even those that require a short-term increase in debt.
Looking away from the UK we find the expectation of dividend cuts to be a global phenomenon. Goldman Sach’s strategy team expects the dividend on the S&P500 to decline by 25% over the course of 2020. Given that US dividends increased in the first quarter, this equates to a 39% decline in the nine months to December 2020. Meanwhile the dividend futures market points to a 55% decline in Eurostoxx 50 dividends and a 20% decline in Japanese dividends. These reductions compare with the cuts experienced in the Global Financial Crisis period of 30% in the UK, 25% in the US, 40% in Europe ex UK and 52% in Japan.
A dividend cut should not necessarily be taken as a sign of weakness. Holdings in Cerno Capital portfolios such as Renishaw and Assa Abloy have reduced the current pay-out and we view this as positive capital management by industrial companies. Our view is that companies in the Global Leaders portfolio should not treat short term cash payments to shareholders as sacrosanct. Taking capital out of the business today would be the wrong thing to do given our observation that this capital can be reinvested in the business at attractive long-term rates of return on capital and this will enhance their industry leading positions. Over time, these businesses are able to pay attractive dividends which grow; however, this is a by-product of careful management, capital allocation, research, development and adaptation.
Indeed, we would go further: companies which prioritise dividends are destined to stagnate. Global stock markets have been wise to this too: high dividend payers rank as some of the worst performers year-to-date. This creates serious issues for investors who target income. Our own approach is to think always about total returns. Cerno Capital is a Total Return manager.