09 Apr 2020
Artemis Income Fund
Over the last week, dividend cheques that were once expected to land on the doormat have instead been disappearing back out through the letterbox. Dividend cuts, postponements and cancellations abound.
While the disappearance of these dividends is unwelcome and worrying, we would make the following observations. Given the rapidly changing circumstances, we would ask you to treat the thoughts presented here with caution – but at times like this, saying something is better than saying nothing.
We can divide these dividend actions into three camps (recognising that some will be an amalgam of two or even all three).
Some companies have (rightly) tried to give a degree of certainty as to how they will weather a prolonged period of inactivity. Cancelling dividends helps them to protect their finances and to minimise the amount of additional debt they might be forced to utilise and /or to lessen the need to raise additional equity. Unfortunately, there will still be many cases where issuing equity will prove unavoidable.
We think of these dividends as being semi-retired: it is likely to be some while before the restoration of the dividend is possible.
To our mind, a fair number of actions (mainly deferrals), represent dividend ‘sabbaticals’. They reflect financial prudence or due regard to the hardship of their customers. It is highly likely that these dividends will return from sabbatical, albeit perhaps not at the levels from which they departed.
In some cases, boards have deemed (rightly) that taking appropriate dividend action is that they will in some way be a beneficiary of the support being promised by government. As such, it would be wrong to reward shareholders at such a time.
These three types of – or motivations for – actions on dividends are generalised across the market. We should, however, make specific mention of the dividends of the banks and insurers.
This week’s announcement that UK banks should cancel their outstanding dividends, although not a surprise, has provoked negative share-price reactions. Our take is that the move is more of prudence rather than necessity. Capital ratios across the banking sector start in a very strong position. This decision adds to this strength, which is what the Bank of England intended. But the decision also recognises that paying dividends at a time when customers and borrowers face a period of great hardship would be insensitive, to say the least.
Although these dividends will no longer reach shareholders, the money hasn’t gone anywhere: it is still part of the value of the company. Furthermore, it provides an additional buffer for shareholders. One of the most value-destructive events for shareholders can be issuing additional shares: future profit share is diluted as a result of their being a greater number of shareholders.
From all we can see, unlike in the financial crisis, future share issuance by the banks looks far less likely, courtesy of their strong capital ratios and the prudent regulatory actions of the last decade. Cancelling dividends further bolsters capital and so reduces the prospect of share issuance. That might not feel particularly positive today, but given where share prices have got to, we think it is.
The Prudential Regulation Authority has asked UK insurers to consider the merits of paying their dividends in the light of their obligations to policyholders (my words). On Thursday, however, Eiopa, the European insurance and pensions regulator, took a harder line. This has been already been rejected by the German regulator – but accepted by others.
Assuming the letter from the PRA still stands, it is a more measured and open guidance than that given to the banks. Nevertheless, insurance shares have fallen in response to the news from Europe.
Like the banks, the solvency of the insurers is much stronger than in past crises. Most insurers have been able to give the market solvency estimates as the crisis has unfolded – so information is better and more immediate than in the past. In a similar way to the banks, we think that dividend cancellations add to their financial strength and lessen the likelihood of any need for share issuance.
Moreover, we think that some companies may still go ahead with some (or all) of their dividend payments if they are confident that this in no way contravenes the regulator’s request. I am reminded of the fact that L&G removed its dividend during the financial crisis but, in hindsight, this was not necessary. Even if the PRA were to fall into line with guidance from Europe, this would suggest a suspension or deferral of dividends rather than a removal.
When will dividends return? Clearly, there are numerous imponderables here. ‘Resting’ dividends is right for now. But they are recognised as an important part of the savings and pension landscape. So their absence should prove temporary rather than permanent.
For sure, dividends may not return at the levels they were before the pandemic. Companies will be understandably prudent and almost certainly less profitable. One positive is that there has in recent years been an increasing friction between dividends and share buybacks as a way of rewarding shareholders. This debate is changing. We suspect that while dividends may be ‘resting’, buybacks may be permanently retired.
Amid the plethora of dividend cancellations and withdrawals it is difficult to be precise about what this means for our portfolio’s yield.
As you might expect, we have been running a spreadsheet with a number of assumptions as to the likely dividend outcomes for our companies. But every time we are poised to produce some sort of guidance, there is another slew of deferral and cancellations. A number given a week ago will likely be in need of revision today. And so it goes on.
So, for now, we are wary of providing number which may prove misleading, particularly since the numbers for 2020 for any portfolio will look stark compared to what was there before. For example, we currently mark oil dividends to a 50% cut. That cut hasn’t happened – yet – so it could be misleading. But in three months’ time it may well have done.
And, to reiterate, we suspect that many of the cuts and cancellations announced will represent dividend ‘sabbaticals’. We believe these dividends will return from sabbatical, albeit not back to the levels from which they departed. Nevertheless we think it likely that 2021 will see a strong bounce in dividend payouts – but gauging the extent of that bounce that is difficult at this stage.
In the meantime, we continue to manage the portfolio in keeping with our investment philosophy of focusing on long-term cashflows. We think it would be wrong to re-shuffle the portfolio to try to capture as much short-term income as possible at the expense of longer-term returns.
We have been looking to add to positions where we are content that the long-term rationale remains intact and where balance sheets are sufficiently strong to cope with the current situation.
A well-timed addition to Smiths Group is perhaps the most notable in this regard. It reported a very robust trading update for the first six months of its fiscal year (to the end of January) and also flagged that in recent weeks that trading had remained positive (mid-single-digit revenue growth).
We are drawn to Smiths Group at this point because we believe it has a good mix of resilient businesses where there is a high degree of secure after-market sales. Although it has some exposure to the challenged airport sector (it is the market leader in passenger and luggage-scanning devices), we believe that this has already been priced in by the market.
We suspect much of this recent weakness is due to disappointment that the rumoured disposal of its medical business has not materialised. We would argue this may be a good time to retain the strong and defensive cashflows this business delivers. There may be some better times ahead for this division.
Smiths Group has low leverage, a pension-fund surplus and strong cashflow credentials, even in a weakened global economy. We also suspect that it could attract takeover interest from numerous trade and private equity parties.
Adrian Frost, Nick Shenton and Andy Marsh, Artemis Income Fund
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