Editors’ note: MarketMinder Europe doesn’t make individual security recommendations; those mentioned here are part of a broader theme we wish to highlight.
With COVID-19 responses roiling business, many companies seem to be looking to build up cash reserves to help themselves get through lean times. For some, it appears dividend payouts are a prime candidate to cut. In our view, this is a timely, albeit tough, reminder for investors about the limitations of relying on dividend-paying shares alone for cash flow.
As COVID-related restrictions disrupt normal business, companies are seeking myriad ways to stay afloat. One easy target: dividend payouts. On 30 April, Energy giant Royal Dutch Shell, one of the UK’s most well-known dividend payers, cut its dividend for the first time since World War II.[i] The firm is part of a recent trend. According to share broker AJ Bell, since the COVID outbreak began, FTSE 100 dividend cuts have amounted to nearly £24 billion—a big reversal from 2020 projections of £91.5 billion in payouts.[ii] Similarly, more than American 200 companies have either reduced or suspended dividends, including dozens of S&P 500 companies.[iii]
Some observers we follow in the financial press warn reduced or suspended dividends signal businesses are in greater trouble than widely appreciated. Whilst cutting a dividend appears like acknowledgment of the stresses hitting a business, assuming it means much more risks going too far, in our view. During challenging times, dividends are often one of the first things to go when companies need cash in anticipation of weathering a downturn, in our experience. Importantly, we don’t think a suspension necessarily means firms are in trouble. For example, the Bank of England (BoE) asked Britain’s largest banks to scrap dividends due to the COVID-19 crisis.[iv] The European Central Bank (ECB) similarly requested eurozone banks suspend dividends and buybacks until at least October.[v] In both cases, the reasons appear to us to be at least partly political, as policymakers argue banks should prioritise lending to struggling businesses and individuals rather than returning cash to shareholders.
From an investing perspective, dividend cuts have spurred several misperceptions dotting the financial pages. One argument we have seen, particularly in the UK: Dividends are the primary source of shares’ returns. Based on price returns—which exclude dividends—the FTSE 100 is down -9.6% since 2015, whilst in total returns (which include dividends), the index is up 12.2%.[vi] All the return, some pundits we have seen cite this fact argue, is from dividends. Hence, if companies cut dividends now, the thinking goes, it could take years for equities to recover. Another popular notion about dividends we have seen crop up during past bear markets: They can act like a “buffer” and provide something for investors when share prices plunge during bear markets—and if those payouts dry up, where will return come from?
In our view, this misunderstands what dividends are. They aren’t interest on a debt security. When a company pays a dividend, the share price falls by the dividend cash amount. It can be difficult to see due to daily market volatility, but it is true—and it makes sense. The company is handing investors a large amount of cash. To account for that, the share price is ratcheted down. This isn’t a decline in value, mind you, because you now have both cash and shares.
Our research shows this goes a long way toward explaining the large gap between the FTSE 100’s price and total returns. The UK market is heavier on sectors with dividend payers, like Consumer Staples, Materials, Energy, Utilities and Financials. Consider: Those 5 sectors represent 52 firms within the FTSE 100.[vii] In contrast, those same sectors comprise 645 of the 1639 constituents—about 39%—of the MSCI World, a diversified global equity index covering 23 developed markets.[viii] Importantly, if companies don’t make those dividend payments, they don’t subtract from the stock price. This is why we focus on total return—price movement plus reinvested dividends. The latter is one component to consider, but it shouldn’t dictate how you invest, in our view.
We have found many investors like dividend-paying shares since they use the payout for cash flow. But as recent suspensions and cancellations illustrate, dividends aren’t a reliable source of cash. Depending on them can be precarious since they aren’t assured. Plus, dividend-paying shares are still shares, which are subject to short-term volatility. In our view, if you have regular cash flow needs, it is critical to identify the specific amount and build a portfolio that keeps this in mind (along with your other goals and needs and risk tolerance, as well as your time horizon, which is the length of time your assets must be invested to meet your needs). Perhaps that includes some fixed income to help dampen volatility swings. Maybe it means you use a combination of interest, dividends and equity sales to meet cash flow needs. But it is unlikely to mean investing with an eye toward maximising dividends, in our view.
Finally, focusing on dividend payers alone can mean missing out on large swaths of the global equity market. For example, in terms of market capitalisation, Information Technology comprises nearly 20% of the MSCI World compared to just about 7% of the MSCI World High Dividend Yield index.[ix] Prioritising dividend shares over others can mean a suboptimal portfolio mix, depending on market conditions.
[i] “Shell Cuts Dividend for First Time Since World War Two,” Ron Bousso, Shadia Nasralla, Reuters, 30 April 2020.
[ii] “Misery for Investors as FTSE Giants Cut Dividends by Almost £24bn,” Mark Shapland, Yahoo Finance UK, 9 May, 2020.
[iii] “How to Rethink Your Retirement Income Strategy as More Firms Cut Dividends,” Sarah O’Brien, CNBC, 6 May, 2020.
[iv] “UK Banks Agree to Scrap £8bn Dividends Amid Recession Fears,” Kalyeena Makortoff, The Guardian, 31 March, 2020.
[v] “Euro Zone Banks Heed ECB Dividend Warning, Swiss Ignore Regulators,” John Miller and Sinead Cruise, Reuters, 30 March, 2020.
[vi] Source: FactSet, as of 8/5/2020. FTSE 100 price return and total return, 31/12/2014 – 7/5/2020.
[vii] Source: FactSet, as of 8/5/2020. FTSE 100 in terms of constituent count.
[viii] Ibid, as of 8/5/2020. MSCI World in terms of constituent count.
[ix] Ibid., as of 8/5/2020. Market capitalisation of MSCI World and MSCI World High Dividend Yield Indexes.
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