We live in unprecedented times. The Covid-19 crisis has radically changed all aspects of daily life and business. Markets have plunged, while companies from across the investment spectrum have cancelled or delayed dividends. Which begs the question: is this the end of equity income investing as we know it?
Don’t look back in anger
Before we address the question, it’s informative to first look back. In general, we were relatively sanguine coming into 2020. Growth was reasonable, valuations fair and dividends still attractive in the context of yielding assets. Ironically, there were signs as we entered the recent reporting season that companies were going to remain generous with their cash payouts (dividends, special dividends and, at the margins, share buybacks).
However, we were growing concerned about where we were in the economic cycle – the longest in living memory – and therefore didn’t expect to see the same kind of market returns as in 2019. Additionally, we were becoming more circumspect about yield at any price and the bifurcation in the market between quality and value.
Then the coronavirus hit – an end-cycle moment?
A strange new world
The depth and ferocity of the market correction has taken a lot of people by surprise and things have moved quickly. One week, the consensus view was that PMIs were stabilising (if not improving) and the equity risk premium was due to fall (analysts had to justify valuation multiples somehow). The next, all bets were off and most analysts deemed the equity risk premium too low.
Meanwhile, valuation metrics became somewhat redundant as share prices moved 5-10% per day (up and down). Investors were hazarding guesses as to what revenues and profits would look like – wipe off a month, a quarter, a year?
For income investors, the sell-off threw up a number of additional curve balls – some challenging, others creating opportunities.
The market’s response to the demand shock has meant a tough few months for yielding equities. In our view, the rout has been driven as much by commentators and hedge funds adopting a ‘sell-first, ask questions later’ mentality, rather than an accurate reading of events on the ground. Cash-generative companies with sound balance sheets fell with the markets. Those that should be able to deliver attractive absolute dividends on a through-cycle basis were also caught up in the race for the exits.
This, though, has left many excellent companies trading at extremely attractive valuations. An ideal backdrop for active investors looking to bolster yield and capture decent medium-term opportunities.
As a 'quid pro quo' for government funding, politicians have ‘suggested’ that companies refrain from paying dividends. As a result, we would expect to see the withdrawal of some previously announced special dividends (e.g. Volvo). That said, depending on the duration of the crisis, this could, in some cases, result in a phasing of payments rather than outright cancellation. After all, companies largely accrued the dividends in question during 2019. Again, this could mean opportunities for active investors.
The European Central Bank instructed lenders not to pay dividends until at least October 2020. This is so the banks have the capital for increased provisioning and post-crisis lending. Nonetheless, there remain a couple of outstanding questions as to whether this guidance constitutes a delay/deferral versus a complete passing of dividends for this year.
The market has been quick to apply this risk to other sectors. But we are not so convinced and believe that there are now ample undervalued dividend opportunities available for the patient investor.
Opportunities in Europe
One of the benefits of investing in Europe is the depth and breadth of the market. This means investors can diversify their income opportunity set without the reliance on a few companies or sectors. Of course, Europe has not been immune to the sell-off; rather, investors have focused on companies where the dividend is relatively high and, therefore, supposedly at risk. It is far more nuanced than that. There are a number of low-yielding (‘growth’) companies that have cut their dividends when they, at first glance, didn’t need to due to their supposedly robust and cash-generative business models. Perhaps evidence of when the tide goes out, we find out who’s been swimming naked…
Some unloved sectors are now back in favour. Take telecoms. From a low-growth, much-maligned area of the market, many telcos look set to benefit as more of us work from home – with the potential for a modicum of pricing power further down the line.
Additionally, some recently loved yielding sectors, such as utilities, have been caught up in the market falls. However, most companies remain relatively immune to Covid-19, while the drive to ‘decarbonise’ the world is already in motion and unlikely to slow. We therefore expect the sector’s newfound growth dynamic to continue apace.
History doesn’t repeat, but it does rhyme
The Covid-19 crisis has brought with it the same challenges as previous ‘Black Swans’ – just in a different form. It is impossible to say how long it will continue or what the lasting impact on economies, businesses and society will be. On a positive note, China appears to be emerging from the crisis and hopefully we will see the peak in Italy and Spain, allowing some confidence to ebb back into markets.
The one thing investors have been calling out for over the last three to four years is fiscal loosening. Well they got what they asked for – let’s hope it is not all spent on bailing out economies versus stimulating growth and corporate profitability. In our view, it is likely to be somewhere in the middle. This will see the strong get stronger, while weak companies and business models may unfortunately wither on the vine.
In the meantime, as investors, we need to remain active and vigilant to both the downside risks and to capturing the upside. If we do, we believe that opportunities will present themselves – and equity dividends will remain a key component of returns, as we navigate through these uncertain times.