A change in the dividend landscape

Banks once dominated over the European dividend base but the crisis has brought changes, with new sectors contributing to the dividend pot. For income seekers this means a change of risk.

Analysts have been saying that most dividends would come from just a handful of companies this year. Now we have lost the banks, what does the future hold for equity income?
It is worth remembering that, historically, the bulk of real equity returns have come from dividends via the compound reinvestment of attractive yields capable of growth. Changes in the earnings multiple accounted for little in the past, and under “normal” conditions dividend payments were a signal of strength and stability in a business.

Cynics can be forgiven a moment of hollow laughter and throat-clearing. Dividends are the last thing to be cut but, when it is a matter of survival, then cut they will be. Indeed, it is not just the number of companies cutting dividends that has been at record levels, but the size of these cuts that has shocked.

According to Citi Investment Research, nearly 40% of companies across Britain and continental Europe cut their dividend in the first half of 2009 alone. That compares with some 25% in the TMT (technology, media and telecoms) aftermath of 2002 and 32% in 1993, after the recession. We have seen the most severe cuts in dividends on record, barring the end of the first world war, with the worst in the first quarter of 2009.

The dividend policy of many companies links payouts to profits, by targeting a payout ratio. Given the collapse in corporate profits over the past 12-18 months, it was not surprising to see widespread dividend cuts as many companies struggled with funding liquidity and solvency issues.

Those sectors that suffered the most savage fall in profits, namely autos and financials, also cut dividends most aggressively. In the hunt for sustainable yield, the sectors with fewest downgrades to dividends include healthcare, consumer staples, telecoms and utilities.

For the British market, there has been a dramatic reshaping of the dividend landscape as a result of the collapse in bank dividends. With material losses and write-downs, there has been little place for a progressive dividend policy.

Some banks, such as HSBC and Barclays, raised cash from investors and are resuming dividend payments at a lower level. Free from capital and political constraints, they should be more able to take advantage of the business opportunities across financial markets.

Investors may have overlooked the fact that the massive dominance the banks once had created a risky imbalance. In pan-European markets, banks accounted for 28.4% of the market dividend base in 2007, followed by oil and gas (9.3%), telecoms (8.6%), insurance (7.9%) and utilities (7.9%). In 2009, according to Citi, the oil and gas sector takes over as the lead dividend payer across Britain and continental Europe with 14.4% of the dividend base, followed by telecoms (12.2%), utilities (10.8%), healthcare (10.4%) and banks (10.2%). There are now five sectors that each account for over 10% of the dividend pot, versus just banks in 2007.

In Britain, seven companies are likely to account for half the dividend base this year: BP, Royal Dutch Shell, GlaxoSmithKline, AstraZeneca, HSBC, Vodafone and BAT. Include the next three biggest payers (BHP Billiton, Tesco and Diageo) and these 10 stocks alone are expected to account for about 60% of all dividends paid by listed companies in 2009.

For income seekers this means the risks change. Where fears might once have been of a windfall tax on banks, now the price of crude oil will become a more pressing concern. Hence the worries when, in March, BP said it was freezing its payout in 2009 for the first time in a decade. The global giant needs an oil price of $60 per barrel if it is to pay for its dividend and its planned capital spending programme from its cash flows.

On the plus side, many of these big dividend payers are dominated by overseas operations where growth continues. Dollar payers offer some protection against the possibility of further sterling weakness. Furthermore, many of these companies have resilient dividends, for example, telecoms, utilities, pharmaceuticals, insurance underwriters and drinks groups. Such areas of defensive growth with their low levels of debt are likely to be steady performers.

Admittedly, such stocks have been dull performers this year when set against major indices. According to Merrill Lynch, the massive rotation from low beta to aggressive, high beta stocks in March and April, was the largest on record – nearly twice the previous record two-month rotation towards high beta that occurred during the technology bubble in late 1999.

This may have signalled a trough in macroeconomic data. Or it may merely be the effect of the massive fiscal and monetary stimuli. Restoring liquidity has boosted financial markets and will provide a slower one-off boost to economies over a couple of quarters. But what happens after the rebound?

An International Monetary Fund study of 122 recessions over the past 50 years in 21 countries makes for sober reading.

Recessions associated with financial crises tend to be severe, long-lasting and end with a weak recovery. On average, recessions which were associated with financial crises and were highly synchronised lasted for just over seven quarters. If Britain entered recession around May, 2008, then a to-be-confirmed, sustainable recovery might not begin until the end of the first quarter next year.

Even then, economic growth is likely to be sluggish because weak banks will be cautious lenders, and consumers are likely to retrench in the face of higher taxes, rising unemployment and a dull property market.

If a decade of high equity valuations was supported by the “great moderation” of steady, non-volatile economic growth that reduced uncertainty over company profits, then
the reverse is likely to hold. Greater volatility in quarterly growth suggests that equities on low price/earnings ratios supported by strong cash flows, robust balance sheets and attractive yields could be the place to be for medium- to long-term investors.