The Investment Association has just reinstated the yield criteria for the UK equity income and global equity income sectors. It is a sign of better health for the two sectors, as companies once again have the confidence to make distributions to shareholders. However, the sector remains widely unloved. Have dividends lost their power to impress?
The inclusion of equity income in a portfolio used to be a no-brainer for investors. There were impressive statistics on how dividends had contributed to total return – the Barclays Equity Gilt Study, for example, showed that £100 invested in equities in 1899 would now be worth £2.7m; strip out dividends and that falls to under £20,000.
Equally, dividend strategies had a natural value discipline – if the share price rose too high and the yield dipped, they moved off the radar for income investors, which meant they tended to buy low and sell high. This meant investors tended not to be vulnerable to ‘hot’ sectors and stocks, but have a more balanced return, an ideal choice for the management of long-term wealth.
When the rot set in
The rot started for equity income funds during the global financial crisis. Banks formed a significant chunk of many income funds. The crisis in the banking sector left many equity income funds with their income depleted and capital values battered. It also set in motion the ‘long duration’ trade, whereby assets with long-term, predictable cash flows were highly valued in a climate of low interest rates and low growth.
The pandemic extended this trade by depressing interest rates still further and exacerbated the problems for the equity income sector. Also, dividends were slashed across a range of sectors as companies sought to shore up cash flows in the pandemic. As Rob Burdett (pictured), co-head of the Multi-Manager People team at BMO Global Asset Management, points out, “all the top sectors over the past few years have been non-yielding: government bonds, technology and so on.”
Performance across the global and UK equity income sectors was weak and investors turned away. Sentiment still hasn’t recovered. In the latest set of Investment Association statistics, UK Equity Income funds saw outflows of £375m, more than any other sector. Global Equity Income funds have fared a little better, but remain widely unloved.
Valuation gap is getting wider
Burdett believes that investors have forgotten the merits of equity income. “The valuation gap with other parts of the market was already wide and now it’s getting wider,” he says. “Even though bond yields remain low and there’s been a recovery in value, it hasn’t been reflected in the equity income sectors.” He sees signs of normality returning to dividend payouts and believes there could be a lot further to go for these funds.
A high profile example of the return of dividends has been the US banking stocks, says Burdett, which have hiked their payouts after the latest round of Federal Reserve ‘stress tests’ gave them a clean bill of health. Analysts had expected payouts to rise, but the level of increase has been a surprise – Morgan Stanley, for example, said it would double its dividend in the third quarter, while Bank of America and JP Morgan Chase & Co raised their dividends by 17% and 11% respectively.
It is a similar picture in Europe. The European Central Bank’s head of supervision, Andrea Enria, has said the central bank would lift its cap on dividends and share buybacks at eurozone banks in the third quarter of 2021. Mining companies are improving their payouts on the back of higher commodities prices, while sectors such as pharmaceuticals have remained resilient. There can be little doubt that payout ratios were too high for many companies in the UK market and the pandemic has allowed dividends to be reset at more realistic levels.
Yield remains scarce elsewhere
Another argument in favour of equity income is that it should also be the natural choice for investors who can no longer achieve decent levels of yield from the bond market or who need to protect their income against inflation. The ‘bond proxy’ trade that was so popular when interest rates first dropped appears to have been largely forgotten, but may be revived if bond yields look likely to stay low.
However, there are still risks inherent in equity income strategies. Callum Abbot, a fund manager on the JP Morgan Claverhouse investment trust, says: “Dividend growth was very weak last year, down around 40% at a market level. Consensus estimates are for a 10% bounce this year… It’s likely to be a good few years until we get to 2019 levels of income for the market.
“Earnings have bounced back, but managers have got a few different things on their plate from a capital allocation perspective. Firstly, CEOs and CFOs are looking to repair balance sheets and pay back debt after a difficult 2020. Secondly, we’re in a good growth environment, so often they are looking to invest into that environment… Finally, some management teams are looking at their share prices and seeing that they’ve not be rewarded for the recovery in earnings or cashflows, so they’re looking to buy back shares rather than pay dividends.”
See also: Improving dividend picture fails to revitalise lagging global equity income sector
‘Old economy’ continues to dominate
There is another drag for equity income funds that will be hard to overcome. The biggest dividend payers tend to be concentrated in ‘old economy’ stocks – banks, oil, mining. These sectors have a headwind amid the current focus on environmental, social and governance criteria. It is difficult and expensive to turn around the environmental performance of an oil company. It takes considerable investment in new technologies. This may make for a better company in the end, but it eats into their ability to pay dividends to shareholders.
That said, this is more than reflected in valuations and a skilled equity income manager should be able to dodge the worst of the problems. For an active equity income manager there should be rich pickings in the market today.
