Six rules for income investing during the Covid-19 crisis

By sticking to a few rules, it is possible to make the most of retained dividends, while also supporting firms redirecting proceeds towards future growth, say Ken Wotton and Brendan Gulston.

The list of UK companies suspending shareholder dividends during the Covid-19 crisis grows longer every day. The Q1 Link Group UK Dividend Monitor, published on 9 April, already showed more than 50% of UK dividends for 2020 – representing £50.6 billion – have been cut or are at risk of being cut, with just 32% classified as 'safe'.

However, aggrieved investors should not simply throw themselves into the last bastions of large-cap income. The picture is more nuanced and requires careful consideration of longer-term implications.

No income investor will be spared from the sweeping cuts. But by adhering to a few simple rules, it is possible to make the most of retained dividends, while also supporting companies redirecting proceeds towards future growth. 

1) Broaden your universe

The wave of dividend cancellations is likely to have a significant impact on large-cap focused income funds, given that more than half of FTSE 100 dividends have historically been concentrated in only 10 companies.

By adopting a broader focus and looking down the market capitalisation spectrum, investors can find smaller businesses dominant in niche areas, which are less susceptible to broad market movements and more insulated from certain global macroeconomic risks. 

For example, we have invested in Strix, the global leader in kettle controls. Its leadership position in this niche market makes the company more resilient to the impact of economic turbulence. Strix recently reconfirmed its intention to pay its final dividend, due this month. We have also invested in Moneysupermarket, another confirmed dividend payer with a market leading position in the price comparison market, a highly cash generative business model and a strong unleveraged balance sheet.

2) Stay sector aware

Financials, historically the largest dividend paying sector, has been the hardest hit. The Bank of England’s mandated 12-month halt in shareholder payments will wipe out £13.6 billion of dividends this year. Other adversely impacted sectors include housebuilders and mining. Energy giants are also reeling from the fall in oil prices, with the FTSE’s biggest payer, Shell, cutting its dividend for the first time since the Second World War.

Cyclicals struggle more in a downturn. Therefore, avoiding these businesses and focusing on structurally attractive market segments, where long-term growth drivers are less correlated with the broader economy, can deliver a more resilient portfolio.

Additionally, investing in domestic-focused companies lowers the susceptibility of dividends to foreign exchange volatility, which can be detrimental for UK investors seeking sterling-denominated income.

3) Stick to your process

Fundamentals-focused analysis is key for identifying the businesses best placed to survive the crisis. It is vital to target profitable, higher margin cash generative businesses, with low or no gearing and strong balance sheets. 

In addition, high dividend and cash flow cover can help determine a company’s ability to continue trading without having to suspend or cut its dividend. Companies with a higher dividend cover can reinvest cash flow into future growth opportunities, thereby offering multi-year earnings growth as well as dividend growth potential.

Investors must regularly verify these metrics, particularly in the current period, where business patterns are constantly changing. Undertaking detailed analysis of operational/business models is also crucial, to work out potential fragilities from a cashflow or operational perspective.

4) Constantly communicate

In addition to gauging a company’s preparedness for the current disruption, it is paramount to actively engage with management teams to assess their response to the evolving situation. The switch to conducting virtual meetings has been rather seamless, with CEOs and CFOs available at relatively short notice. In fact, we have found meetings to be highly focused and sometimes more productive than face-to-face encounters.

These discussions serve to understand what difficulties companies are facing on both a supply and demand front and what measures are available – such as renegotiating supply arrangements, imposing pay cuts or calling on government schemes.

Speaking directly to management helps gain a better sense of how proactive and flexible a company is being in its reaction to the crisis and planning to mitigate downside scenarios. We need to have comfort management is on the front foot and rapidly responding to protect and reposition the business in the new environment.

5) Consolidate your convictions

Elevated levels of volatility warrant a degree of caution. Going into the Covid-induced crisis, our capital reserves were higher than usual, and we have not rushed to deploy cash too quickly. Instead, now is a good time to consolidate positions in high conviction investments. In companies where the dividend is secure and will be paid in the near term, committing further capital can lock in returns and contribute to annual income targets.

Elsewhere, fallen valuations can provide a timely opportunity to purchase bigger stakes in fundamentally sound businesses. In the leisure sector, which has seen revenues fall to zero in the short term as a result of lockdown measures, we participated in several recapitalisation deals to help businesses survive and emerge stronger from the crisis.

Low-ticket experiential leisure remains attractive over the longer term, as it is less exposed to consumer belt tightening than some other areas of spending. As such, we recently backed a fundraising by Ten Entertainment Group, a leading ten-pin bowling centre operator that should emerge from the crisis as a long-term winner in its niche market.

6) Make calculated cuts

With such high uncertainty in the market, it is also necessary to make tactical divestments. Sub-scale positions in lower conviction stocks can be used to free up liquidity. In addition, investments in businesses where valuations have not fallen enough, given how much operations may be hit, can be redeployed into more attractive opportunities.

Finally, it is crucial to anticipate second-order impacts beyond the imminent recession. Once economic activity resumes, certain business areas will take longer to recover. For this reason, we have cut holdings in more cyclically exposed companies, where the road to recovery will be lengthy.

In summary, navigating the dividend environment in light of the disruption caused by the current crisis is challenging for all. We welcome the news from the Investment Association that dividend yield targets for funds in the IA UK Equity Income sector will be temporarily suspended. As a result, some funds may offer substantially reduced yields to their investors during 2020 as they focus on rebuilding portfolios for next year.

However, by implementing our six rules and hunting for niche segments of resilient income, we believe it is possible to provide investors with an attractive yield and diversified sources of income while also taking advantage of investment opportunities to deliver strong total returns in future years.

Ken Wotton and Brendan Gulston are co-managers of the LF Gresham House UK Multi Cap Income Fund.