It has been a bleak year for income investors, but there are reasons for optimism in 2021.
It has been widely said by fund managers that Covid-19 has accelerated certain pre-existing trends, which has created both winners and losers.
The standout winners, following millions of people shifting to work from home, have been technology businesses. Among the losers have been sectors and industries that prior to Covid-19 looked structurally challenged and now appear in terminal decline, such as bricks-and-mortar retailers that do not possess an online presence.
Income-seeking investors, particularly those backing UK funds or shares, have also been among the losers, following widespread dividend cuts in response to Covid-19. The latest figures from Link Group, which monitors UK dividend payments, forecast a 39% year-on-year decline for dividend payments in 2020.
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While this is a blow for income investors, the UK dividend cuts are another example of the acceleration of a pre-existing trend, notes Blake Hutchins, co-manager of the Trojan Income fund.
He says: “For a while, ahead of Covid-19, the UK market stood out for its high dividend yield versus other countries. We took the view that there was trouble ahead and a day of reckoning, as we felt the biggest dividend companies in the UK were struggling to grow and therefore the dividends were looking less and less sustainable.
“Covid-19 has accelerated the decline of certain industries, which has put pressure on these big firms, which dominate the headline figure for overall dividend payments for the UK market.”
At the start of 2020, payments from the 15 biggest UK dividend payers were expected to account for 60% of all income paid out from UK-listed companies.
Ahead of the dividend drought playing out, the Trojan Income fund moved into an even more defensive gear than usual (it ordinarily adopts a cautious stance) in the second half of last year. Exposure to holdings with market-beating yields (4% plus) that were deemed to be over-distributing on the income front were reduced. Holdings kicked into touch included utilities Severn Trent (LSE: SVT) and Pennon (LSE: PNN), while Royal Mail (LSE: RMG) was also sent packing.
The proceeds were used to invest in “higher-quality businesses”, says Hutchins, that tend to have lower dividend yields but greater scope for dividend growth, as a sufficient amount of cash is being generated to pay dividends. Croda (LSE: CRDA) and Intertek (LSE: ITRK) were two new holdings added to the portfolio.
Hutchins cautions that in 2021 dividends for the UK market as a whole are going to be “lower in the future (compared to 2019 dividend levels), but at more sensible levels”, which he views as a silver lining.
Another potential silver lining, which will give income-seeking investors hope that 2021 will be a better year, is that companies that have suspended dividends are ready to resume payments, according to Kevin Murphy, co-manager of the Schroder Income fund.
However, Murphy also cautions that 2021 will not be the year when dividends for the overall market return to prior levels.
UK dividend payments hit record levels for three years on the spin (2017, 2018 and 2019), with payouts last year coming in at £110.5 billion. To put this figure in context, this is more than double the total value of dividends paid a decade ago (£54.6 billion) following the global financial crisis. For 2020, Link Group expects UK dividends, excluding special dividends, to fall to around £60 billion.
Murphy says: “Companies want to pay a dividend and have the cash to do so, but do not want to look foolish through the lens of hindsight. On a 12-month view, large numbers of companies will come back to the dividend register, but it may not be at the same levels of previous payments.”
He points out that, from a mathematical point of view, the greatest prospect for dividend growth is when a share cuts its dividend, which is another silver lining. Therefore, Murphy expects 2021 to be a better year for income seekers.
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Responding to the dividend drought
Schroder Income’s performance suffered in 2020 due to its deep value approach of investing in out-of-form shares that have dividend potential. In response, Murphy says that he has tilted the portfolio to become more diversified, but still maintain its value credentials. Two new holdings are M&G (LSE: MNG) and ITV (LSE: ITV).
First, he is focusing on “suitably high levels of income from shares, which in our opinion also have the potential to grow these in future, [and] also having good weightings to shares that may have a lower perceived credit risk than the UK government. We believe GlaxoSmithKline (LSE: GSK) has been a good example.”
Second, Dixon is targeting shares with both an attractive yield and the prospect of catching up payments for foregone dividends. “Here, we want to isolate companies that took an extremely conservative approach during the pandemic, and have continued to trade well. Morrisons (LSE: MRW) would fall into this category.”
Finally, Dixon has exposure to shares that fully cut their dividend. He looks for those that “have been poor performers, but in our view can return faster than their sector to dividend-paying status”.
He adds: “Persimmon (LSE: PSN) managed this in the housebuilder sector and has outperformed its peers. Within banking we are pleased by Close Brothers' (LSE: CBG) return to dividend-paying status and it, too, has outperformed its sector.”
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