5 dividends questions answered
With so many investors reliant on dividends to boost their income or support their retirement, we asked Nick Kirrage, Co-Head of the Value team, for an update on what's happening now, whether investors should be concerned and how the future of dividends might look.
Q1: What’s likely to happen to company dividends post the onset of COVID-19?
Dividends are the cashflows that a company elects to pay out to its shareholders as a reward for holding the shares over time. We hope that if they are good, growing businesses, companies can pay from their profits. They can also dispose of businesses that they own or raise debt to pay their dividend. When times are very good, there might be windfall profits and a lot to be paid out in dividends. When times are bad, there might not be, but a company might find other ways to keep its dividend going through the tough times until things get better.
At the moment, quite amazingly, there is a broad consensus from the vast bulk of companies that they are going to cut their dividends and hoard their cash. They want that security, and liquidity, which just means cash in the bank to give them options and security while things are tough.
Q2: There has been discussion around companies cutting their dividends. This leaves a huge hole in investors’ income, doesn’t it? For people in retirement, and those that use those dividends to top up their monthly income, that is going to be tough.
That debate is yet to come. Right now, the average company sees no downside to cutting its dividend, and things are changing so quickly. It has become very consensual to cut the dividend. People will accept and understand it, so it seems reasonable. This means companies are cutting their dividends, whether or not they can pay them.
I think that the debate will move on to the second order effects. Although it seems like it is not impacting anyone, it is actually hitting a lot of people. The charity sector will be hit extraordinarily hard. The dividends received by charities support millions of pounds worth of charitable work, which is needed now more than ever as well as supporting employment within those charities. For charities and for retirees, the debate will move on to whether this is actually doing more harm than good. Should all companies cut dividends even if they don’t need to?
Q3: Two of the main ways to receive dividends are as cash or you can opt to reinvest to benefit from the effects of compounding, basically earning returns on returns. How does this work?
It is extraordinarily difficult to replace dividends as they are a huge part of the returns over the long term. Reinvesting dividends means that they then earn money, then pay dividends and that then reinvests. This is called compounding and Albert Einstein described it as “the eighth wonder of the world If you lose these dividends, even for a short period of time, it can have a dramatic impact on the returns that you make over the long term.
Q4: What is next for dividends after the virus? As an investor, income makes up a significant proportion of your returns, what would you be telling investors at this point?
Long-term dividend growth does not always just go in one direction. The stock market has long periods with consistent gains and then there will be a very big setback. Historically, dividends have tended to be less volatile than the stock market itself. This is because businesses try and maintain dividends when times are tough, even if profits are under pressure.
This downturn is going to be different because so many businesses are having a dividend hiatus. The effect of a market-wide dividend cut will be magnified in a very concentrated market. It is important to note that many companies’ dividends are not going away because they cannot pay them. In the case of banks, or oil and gas, which represent a large part of the cuts, it is really just dividends deferred not destroyed. Dividend cuts from smaller and more directly-affected sectors by the virus, such as airlines, travel and leisure, are probably gone for a period of time. We will have to wait to see them return.
Q5: Thinking about why investors buy specific shares in the first place, has something fundamentally changed?
When investing in a company, investors are trying to construct a portfolio which does three things if you think about income. The first is: will it produce a decent dividend yield? Over time, you want that payout to grow so investors target dividend growth – the second leg. A growing business can pay out a bigger dividend in the future. Then the third leg, which is very important, is seeing capital growth, which needs to compound.
I always think of this as a stool with three legs - if any one of the legs is too short, then the stool falls over.
In the short term, investors might have businesses that are cutting their dividend but they might not sell them because they think that their long-term prospects are good. Investors should really think about the long-term prospects.
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