“Loves are like empires; when the idea they are founded on crumbles, they, too, fade away.”– Milan Kundera, The Unbearable Lightness of Being
Like a broken marriage vow, the recent bout of dividend cuts and suspensions around the world have left equity investors disappointed with the reality that dividend commitments are not as sacrosanct as they had earlier hoped for.
As the impact of the Covid-19 pandemic and extended lockdowns around the world take their toll on cash flows and corporate profitability, dividends may become a luxury for companies struggling to conserve capital and stay afloat.
With several high-profile dividend suspensions (by UK and European banks on regulatory pressure) and dividend cuts (Royal Dutch Shell’s first cut since 1945) in recent weeks, investors need to be far more discerning about their choice of dividend-paying stocks through fundamental research.
To date, 38 companies or 9% of the 420 S&P 500 constituents that paid dividends last year have announced either dividend suspensions or cuts in 2020 and beyond – and so have 185 companies in the Stoxx Europe 600 Index. Dividend futures traded on major equity benchmarks in the US and Europe already show a significant reduction in dividend expectations (see Exhibit 1).
Here in Asia, the consensus forecast for the MSCI Asia ex-Japan dividend per share for 2020 has been cut by about 12% since January.
The impact of reduced dividends has significant impact on equity fund flows. According to EPFR data, USD1.3 trillion or 7.6% of USD17 trillion of equity funds under coverage are classified as dividend funds. These funds may experience outflows if developments on the dividend front start to impact investor expectations. There are over 100 dividend exchange traded funds listed and domiciled in the US alone, with total assets of close to USD150 billion.
At the individual company level, dividend cuts or suspension by selected companies may also compromise their eligibility to be held within such funds. Notably, the UK plays host to a disproportionate percentage of dividend funds, with such funds accounting for 21% of total funds, compared to 7% in Europe ex-UK, and 8% for global developed market funds.
Dividend income is an important component of total returns for equity investors in addition to capital growth, so a reduction in expected dividends would impact the expected returns for the asset class as a whole.
Shareholder registers of “traditional” – and dare we say, “defensive” – dividend payers are dominated by pension funds, large dividend funds, and other yield-hungry institutional and retail investors reliant on the dividend income to fulfil their own cash flow needs and expectations. The latest disruption to this long-held belief reminds investors that dividends are far from sacrosanct.
Royal Dutch Shell, the energy industry’s bellwether stock widely held for its 75-year dividend track record, shocked the markets with a 66% cut of its first quarter dividend to 16 US cents (compared to 47 US cents for the fourth quarter). The cut will save Shell about USD10.5 billion per year, so the rebased dividend could give the firm greater financial flexibility over the long term, and allow for debt reduction and reinvestment, according to Morningstar analysts.
Announcing this, Shell CEO Ben Van Beurden took pains to explain the need to balance shorter-term shareholder distributions against the longevity and potential growth of these returns, against a backdrop of prolonged economic uncertainty, weaker commodity prices, higher volatility, and weaker demand.
Dividend commitment – how deep is your love?
Dividend-paying companies are known to publicize their dividend policies to shareholders as a commitment to deliver dividends that grow over time in line with their earnings power and capital structure.
This oral tradition has lulled equity investors into expecting such payouts as a given when doing their sums for expected total returns from owning a stock. For analysts, these dividend expectations have also been baked into models to compute the implied value of stocks. Yet, more companies globally will likely invoke the clause “barring unforeseen circumstances” for the next season of 2020-2021 dividend payouts.
Viewed through a long-term investing lens, investors should not perceive dividend cuts negatively if the decision is a prudent move by companies to conserve capital during a period of stress. In contrast, continued dividend payouts funded by debt issues should be viewed with caution for the longer-term health of corporate balance sheets.
To pay or not to pay?
The determinants of this important corporate decision – to pay or not to pay – is a complex one and fraught with many variables. The decision tree is a combination of both art and science:
Central bank support: Paying the price
European banks were asked by the European Central Bank on 27 March 2020 to halt payments of dividends and share buyback for the financial years 2019 and 2020 until at least 1 October 2020. The move to capital preservation mode was aimed at boosting banks’ capacity to absorb losses and support lending during the Covid-19 pandemic.
Overall, the suspension of payment of final 2019 dividends is estimated to conserve ~EUR21 billon for the Eurozone banks under BOS research coverage, with the median bank estimated to increase their common equity Tier 1 ratio by 0.6% to an average of 13.4%. While this is a disappointing outcome for yield-focused investors in the near term, we view the conservation of bank capital as a sensible move in view of the economic slowdown and earnings pressure in the months ahead.
UK banking CEOs also received signed letters on 31 March 2020 from Bank of England deputy governor and Prudential Regulation Authority (PRA) CEO Sam Woods, requesting them to suspend dividends and share buybacks until the end of 2020 and to cancel payments of any outstanding 2019 dividends.
UK’s five largest banks – HSBC, Standard Chartered, Barclays, RBS and Lloyds plc – deemed to be “systemically important UK deposit takers” complied promptly. They had been due to pay out at least GBP7.5 billion over April and May. The short-term impact of dividend cuts on shareholders had to be juxtaposed against a “sensible precautionary step given the unique role that banks need to play in supporting the wider economy through a period of economic disruption, alongside the extraordinary measures being taken by the authorities”, the PRA advised.
Who’s at risk?
In our latest investment Strategy report, Peering Into the Post-Pandemic World, we highlight that companies are under tremendous pressure to shore up their balance sheets with greater liquidity, longer term funding and reduced leverage as they shift their focus to building resilience in the face of the unprecedented demand and supply shocks from Covid-19. For many companies, this portends lower dividend payouts, reduced share buybacks and capital expenditure plans, and more capital raising from investors.
Vulnerable sectors that are badly affected by the virus outbreak, such as airlines, energy, retail malls, autos, hotels and offline leisure will be in survival mode. Poorly capitalised companies will need to conserve capital in the first instance (shelving any form of capital returns such as dividends and share buybacks), followed by coming to market for capital raising. National carriers, such as Singapore Airlines, are already tapping the capital markets to tide through the turbulence.
Selected companies – no cuts, for now
Despite the Covid-19 challenges, some companies – from the consumer, insurance, chemicals and healthcare sectors – have recently reiterated commitments at virtual annual general meetings to pay dividends for 2019. For the coming quarters, their cautious optimism to be able to sustain dividend payouts is tinged with caveats around the sustainability of their cash flow generation. Even within the hard-hit oil and gas sector, selected US and European majors such as ExxonMobil and Total have articulated their commitment to dividends.
The dividend yielders’ playbook
We encourage equity investors seeking dividend yield amidst the unpredictable future for dividends to consider:
Finally, investors are reminded that dividends are only one aspect of the total returns expected for a company’s stock, which ultimately represents exposure to the longer-term earnings power of a company and its business. The sustainability of a company’s business model and ability to generate long term value will still be the key criteria for investment.
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Version: March 2020