• Financial Framework

The opportunity that dividend cuts produce

For long term investors, extreme market movements can be an opportunity to take advantage of unforeseen circumstances.

Into the 3rd week of the UK lockdown and across the country and the world behaviour has changed. Whether it’s restrictions on what you can buy at the supermarket, the increased use of technology to speak to loved ones, or the huge increase in the number of volunteers helping those in need, it’s no doubt changing the way we live.

It’s not just people who are changing. Companies are adapting to the ever evolving pandemic, and reacting to the financial impact. Dividends are being cut, and shareholders are losing out. Last week, HSBC suspended its dividend for the first time since the Second World War.

Economically, dividend cuts make sense. Equity investors share in the fortunes of a business, good or bad. So in a good year, if a company makes a decent profit and doesn’t see the need to reinvest all the proceeds in the business, paying it back to the shareholders – the owners – is often the right thing to do.

And the inverse also holds true. If a company believes it may require the cash to stabilise the business through a tough time, shareholders should respect that – their investment is being protected for the long term by the people running the business. No one is automatically entitled to a dividend.

That’s the theory. The reality is that investors come to expect dividend payments from businesses, indeed many rely on dividends for income. The financial industry doesn’t help – putting together funds and indices composed of companies who are ‘reliable’ dividend payers, which isn’t the same as ‘guaranteed’. The low interest rate world has made the problem even worse, as investors have replaced low-yielding bonds with high-dividend paying equities in the process moving from low-risk assets to high-risk assets, sometimes without even noticing.

COVID-19 has hit dividends hard.

Some companies are looking at a rough next few months, and boards have decided that in the short term cash would be more useful in the business than in the shareholders’ pockets. Other companies are being forced to cut dividends if they want assistance from the government. In Europe, specific restrictions have been placed on companies listed in France or Germany. Globally we are seeing restrictions on banks, who are still paying for the sins of the last crisis. The loans and grants available come with explicit restrictions on how they are to be used; for protecting workers, not rewarding shareholders.

Still, other companies are watching the way the wind is blowing – even if they are in good shape. Why risk the bad press from not cutting dividends? Cut this year, be a good corporate citizen, and then get the shareholders back on side over the next twelve months with promises of special payments in the future.

All of this disruption has caused extreme stress in the European dividend futures markets, where you can buy and sell the stream of dividend payments for any given year. Given recent announcements, the stream of payments in 2020 is going to be a lot lower than expected a month or so ago. Looking to 2021, the economic disruption is likely to mean lower earnings, even if companies want to start paying out again. The prices of these instruments have fallen by 50% since the start of this year – for good reason – and those announcements are not going to be unwound in the near term. However, the value for the 2022 and 2023 payment streams have fallen by similar amounts.

Our investment partners at 7iM have had European dividends in and out of portfolios since 2012. They’ve become familiar with the market, adding positions when they seem cheap and taking profits once the value is realised. This has been another opportunity so they’ve bought 2022 and 2023 maturity dividends, at what they believe are significant discounts.

By the end of 2022 they believe that Europe’s companies are going to be earning money again and looking to return to normal, enticing shareholders with dividend payments. The current entry price also builds in a decent margin of error – even if European businesses only pay what they paid at the depths of the Global Financial Crisis in 2008, they say their return will still be mildly positive.

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