What are the prospects for dividends in the UK?
Following six years of healthy dividend growth in the UK market, we believe it is sensible to expect the next few years to be more challenging.
Aggregate market dividend estimates have been falling, with commodity stocks, particularly the miners, suffering the highest profile cuts. Even excluding commodities, market forecasts expect dividend growth to slow in 2016. But is the outlook that bad?
We highlight there is still strong potential for dividend growth to be found in sectors such as non-life insurance and software.
Headwinds from mining, oil and banks
The dividend pot of the UK market has grown significantly since the financial crisis from around £50 billion in 2009 to almost £80 billion today.
Even on a per share basis (i.e. adjusting for increased share count increases from equity raises) we now stand about 10% above the prior peak.
The darkening prospects for commodities, and increasingly the banks, have been the catalyst for investors to reappraise the prospects for market dividend growth.
Mining has undergone the biggest sea change. The sector which once represented a significant 10% of all UK dividends is likely to represent only 2% in 2016, with risks biased to the downside.
China’s slowdown and diminished appetite for infrastructure investment has crushed the price in key commodities such as iron ore, leading to pressure on cashflows and dividend cuts from the key players.
The story from the oil majors is likely to be slower to play out but recent comments from BP’s chairman, Carl-Henric Svanberg, clearly hinted at a dividend cut unless the oil price recovers.
With around a fifth of UK dividends coming from oils this represents another meaningful headwind to dividend growth for the coming years.
Turning to the banks, slowing global growth and increased deflationary pressures have fed a low and flattening yield curve leading to cuts to bank profitability. Each bank has its own issues:
- Continuing limited visibility on litigation payments (Royal Bank of Scotland)
- Concerns around emerging markets and commodity exposure (Standard Chartered)
- Restructuring issues (Barclays)
- Concerns over dividend cover and scrip dividend dilution (HSBC)
Nonetheless bank dividends, in sterling terms, are still expected to grow in aggregate this year though we caution that unless economic growth expectations stabilise there could be more cuts to come.
The only major bank to contrast with this theme is Lloyds Banking Group whose management indicated significant dividend growth is likely for the coming years – only time will tell if management are right.
But it’s not all bad news
Away from resources and banks the picture is better. Insurance, travel & leisure, pharmaceuticals, software and housebuilders should all show double digit dividend growth this year.
Within insurance the non-life insurers have been trading well and best of all is perhaps Admiral. Chart 1 below shows Admiral’s strong dividend track record since listing in 2004.
In addition there has been a further step-up in its shareholder payout announced for 2015 (the final year of the long-serving CEO, Henry Engelhardt).
Whilst there is good news to be found, the sectors listed above growing double digit only represent around a fifth of the total market.
Chart 1: Admiral dividend track record
Source: Admiral, April 2016. For illustrative purposes only and not a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated.
Dividends rely on the business cycle
Turning to the sectors neither in structural decline, nor benefitting from a supernormal growth, we must accept their prospects are subject to the wider economy (or perhaps financial engineering by, for example, balance sheet re-leveraging to pay special dividends).
Global growth estimates have been declining over the last six months, currently standing at +2.5% for 2016, following +2.6% in 2015 (source: Citigroup). The negative momentum is quite broad based, emanating from both emerging and developed markets.
UK growth expectations are also being cut and whilst this can be partially attributed to Brexit uncertainty, weakness in global trade presents an underlying headwind.
As Chart 2 below shows, aggregate financial leverage (borrowing) and payout ratios have been increasing over recent years, leaving less room for manoeuvre in this slowdown scenario.
Chart 2: Dividend metrics in the UK market
Source: Factset, April 2016. Dividend cover measures the number of times a company's most recent dividend can be paid out of its annual earnings. ND/EBITDA is net debt divided by earnings before interest, tax, depreciation and amortisation and gives an indication of a company’s ability to pay off its incurred debt.
Focus on dividend security
Following six years of healthy dividend growth, as we now stand in the slowdown phase of the cycle, it is sensible to expect the dividend environment over next few years to be more challenging.
Total dividend distributions are well above (40%+) their 2008 level and even on a per share basis (i.e. adjusting for capital raises) payouts now stand around 10% above their pre crisis peak (see Chart 3 below).
Chart 3: Dividend per share of UK market now above pre-crisis peak
Source: Datastream, Citigroup, April 2016. Past performance is not a guide to future performance and may not be repeated.
Across our income strategies, in which we run £1 billion of client funds, we try to deliver a premium level of income alongside long term capital growth by thinking of stocks in three groups:
- Premium yielders (those stocks with above market yield but limited growth potential)
- Dividend growers (those stocks normally with a market or sub market yield but which can offer superior growth across the cycle)
- Those which offer capital returns (stocks with very limited or no dividend but good capital growth potential).
During the slowdown phase of the cycle we would tend to tilt the portfolio towards stocks offering growing dividends alongside an allocation of sustainable higher-yielding assets.
Consequently across our income strategies we have become increasingly focused on dividend security. We employ a number of screens on cashflow and balance sheet strength to identify stocks whose yield is sustainable and, of course, those where it’s not.
This brings us on to the topic of the importance of portfolio construction in the UK market. In our view, the more highly concentrated dividend profile of the UK market should suit the active management approach.
As Chart 4 below shows, the UK market is dominated by some key payers with the top 10 representing just under half of the total.
Chart 4: Biggest distributors as percentage of UK market total
Source: Datastream, April 2016. For illustrative purposes only and not a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated.
This concentration in payout means UK income investors can potentially achieve superior outcomes to the market through taking active positions on these bigger payers and portfolio construction.
Challenges ahead but UK remains attractive for income investors
So after a good run UK dividends might pause for breath over the next few years.
There are still areas of strength, but with the business cycle in its slowdown phase dividend growth will be harder to come by. Consequently we’re focused on identifying secure and growing dividends across the UK market.
With alternative asset classes such as bonds often offering negative real yields, we think the FTSE All-Share’s yield of 4% continues to offer value to investors.
By comparison with other geographies, UK corporates have a particularly strong dividend culture and this discipline should benefit investors over the coming years.
Stocks and sectors mentioned are for illustrative purposes only and not a recommendation to buy or sell.