Equities are an important source of income for many, but with dividends being widely cut in response to the Covid-19 crisis we look at what this means.
Since the financial crisis more than a decade ago, investors have had to search much harder for income as savings rates have plunged. Many have looked to the equity market to help them achieve better income returns, with large numbers of companies increasing dividend payments to shareholders as they have grown.
It is likely that equities will continue to provide a relatively attractive source of income for those comfortable with the risks of investing in the stock market.
However, regrettably, dividend payments for most equity income investors are likely to be lower than in previous years for the foreseeable future as a result of the coronavirus crisis. Here we explain why and give our views on the outlook for dividend payments over the medium and longer term.
Equity funds that have a focus on investing for income as well as the potential for capital growth are called equity income funds.
A dividend is an income payment from an investment. The dividends that investors receive from an equity income fund directly reflect the dividends received from companies that the fund holds shares in. This money is paid out to unit or shareholders in proportion to the size of their holdings.
One aim in managing an equity income fund can be to increase dividend payments to investors over time. A manager may aim to achieve this through focusing investment on successful businesses that have the potential to increase their dividend payments as they increase their profits.
The income and capital value of an equity income fund can go down as well as up and investors may not get back the amount they invest.
The coronavirus crisis has blown the carefully laid plans of large numbers of companies around the world way off course. For the time being, the revenue streams of many good businesses have been drastically reduced. And for some, in the most exposed sectors, they have effectively evaporated. All the while, there are costs that must still be met alongside obligations towards key stakeholders including employees, customers and suppliers.
As in any crisis, there are exceptions – some supermarkets, for example, have experienced a surge in sales during the lockdown period – but the management of a great many companies now have a single overriding focus: navigating their way through the current unprecedented conditions as best they can.
It should therefore come as no surprise that many companies have announced that they are reducing their dividend payments or in some cases, suspending them entirely. In most cases we believe this should be welcomed in the short term as it will provide necessary funds to shore up businesses, helping them to ensure their long-term viability once the immediate crisis has passed.
We expect to see more companies follow suit over the coming months, with many likely to err on the side of caution in setting their dividend policies, given the high degree of uncertainty we are all living with.
Companies that have been forced to accept Government assistance will find it difficult to continue paying dividends. And in some countries banks have been instructed not to pay to a dividend to preserve capital so that they can provide finance to companies that need it.
When investing in equities for income you are left with a choice between trying to maintain the level of your dividend income or accepting that it will fall.
Importantly, this does not have to mean abandoning an aim to grow your income over the long-term. This can sensibly remain a key consideration in your stock selection. Instead you may wish to consider each company on an individual basis, assessing how well they are positioned to come through the crisis without fundamental changes to their long-term business case, which will impact their ability to pay dividends going forward.
An insistence on maintaining the dividend of an equity income fund in the current environment would, in most cases, force you into investing in a narrow, less diversified range of stocks. Accepting a cut in the dividend on the other hand can allow you to maintain a focus on investing in the companies that are most likely to help you achieve your long-term objectives in both income and growth terms.
In the wake of crisis situations, companies that have cut their dividends to prioritise cash holdings that enable them to operate and trade effectively can often recover faster than those that have blindly pursued the maintenance of dividend targets set in a completely different environment.
When the economic environment improves, these companies have the potential to restore and grow their dividends again from a position of comparative strength. A look at past crises shows that the overall impact on the intrinsic value of a business from a temporary dividend cut is generally small and, for long-term investors, it is important not to lose track of that fact amid the short-term market noise.
The shape of the recovery from the coronavirus crisis remains far from clear. There are indications that the strict lockdown conditions in place in many countries could be relaxed reasonably soon, enabling some limited activity to resume.
Realistically however, we all face a long wait for anything approximating ‘business as normal’ to resume, given that the only route to achieving this appears to be the development and implementation of an effective vaccination programme on a global scale.
This is unlikely to come together until well into next year, even if one of the vaccines that have already begun human trials proves effective.
This means that dividend payments over the next three years or so are likely to remain well below levels seen in 2019. There is no precedent for the current crisis but estimates of the eventual cut in dividends for the UK market as a whole in 2020 have so far ranged from around 25% to as high as 50%.
Active fund managers are free to choose the combination of companies that they believe will best serve the interests of investors. This gives them some leeway to avoid the full impact of the aggregate dividend cut for the market, but significant cuts in dividend payments for equity income investors should be expected nevertheless.
Longer term, a return to ‘business as normal’ for the economy is likely to lead to a return to ‘business as normal’ for dividends and by extension equity income funds.
It is possible that we could begin to see more companies around the world adopt more conservative dividend policies along the lines of Asian businesses. However, the aftermath of past crises would suggest that while companies may change their behaviour for a couple of years, they often then revert to the way that things were before.
The value of your investments and the income received from them can fall as well as rise. You may not get back the amount you invested.