The advent of Covid last year and the associated lockdowns imparted a significant deflationary shock to the global economy. Profits in many sectors came under significant pressure but particularly so in the more economically sensitive areas of the market. Although the outlook seems somewhat brighter today, at that time, there was no way of knowing whether it would be possible to find a vaccine to protect against the disease in a reasonable timeframe and therefore how long the crisis might last. Given the enormous level of uncertainty that they faced, many companies moved quickly and aggressively to protect their finances by cutting cost, drawing down lines of liquidity and, in many cases, either cutting or cancelling their dividends.
A change is gonna come
It is sometimes said that ‘It’s an ill wind that blows no good’, and in one respect this has proven to be the case with companies that were already having to adapt to secular change in their industries. As a result of the short-term strains that resulted from Covid, companies were forced to accelerate change that was already necessary but would have taken some time to bring about. Several companies that we regularly talk to have said that a change that might previously have taken three-to-five years to bring about is now happening much more rapidly. Companies often surprise in their ability to adapt to a new operating environment – that seems to have been the case here, with many using the crisis to significantly re-engineer their business models. This provides comfort that they should be able to regain prior levels of profitability and grow their profits over the long term.
Back to black
Although we couldn’t know it a year ago, the success of the vaccines has enabled economies to open up more quickly than we would have dared to imagine. Whilst there continues to be a high level of uncertainty, the recovery of the last nine months has certainly been vigorous. The sharp slowdown that we saw in 2020, makes year-on-year comparisons largely meaningless and it is therefore more instructive to compare today’s activity levels with those of two years ago. Some sectors of the economy continue to operate much below 2019 levels (travel and leisure, for example), but many have now largely recovered (such as industrial goods, advertising, retail and housebuilding). The very significant rally in commodity prices (often to levels much higher than they were in 2019) also suggests that economic activity has largely normalised, at least for the time being.
At the company level, the combination of economic recovery and reduced costs has led to a sharp rebound in profits for many businesses and, although the stock market has responded to factor in the improved backdrop, in many cases, share prices have failed to keep pace with the profit recovery. The result has been a de-rating of the TM RWC UK Equity Income Fund portfolio to an aggregate price earnings ratio of just 10-11x earnings for 2021. This corresponds to an earnings yield of 9-10%.
How soon is now?
This relatively sudden improvement in fortunes has created a dilemma for company managements as to how quickly and at what level dividends should be reinstated. There is a strong argument to suggest that company boards will be cautious when setting pay-outs as once a board has taken the painful decision to cut a dividend, the last thing that they want is to cut again. We think it is likely therefore that dividend pay-outs are reintroduced relatively slowly, and that dividend cover is progressively run down over time.
There is still room for positive dividend surprises, however, and the portfolio has benefited from several recently. Examples here include BP, which announced that it is now targeting dividend growth of 4% per annum from a starting dividend yield of more than 5%. Meanwhile, Royal Dutch Shell also increased its dividend by 38% in the second quarter and now also targets 4% per annum dividend growth.
The banks were prevented from making dividend payments in 2020 by the regulator. These restrictions have now been lifted allowing the companies to make generous pay-outs once again. Likewise, several retailers and media companies are expected to see increased dividend payments in 2021.
Run for cover
In the medium to long term, and as normality returns, it is not unreasonable to expect that dividend cover might return to historical levels of around two times. With dividend cover today being closer to three times, this suggests that they should be set for a period of strong dividend growth in the years ahead.
Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team, as at 30th September 2021.
