The UK has built up a reputation as an income-focused and indeed income-friendly stock market. It contains a number of well-established and high-profile income-producing sectors while dividend-related strategies in the UK have a long and proven track record of rewarding both income-seeking investors and income-paying companies.
Obviously this situation has many positives, to which The Value Perspective often refers, but there is also a darker side as many businesses become caught up in the idea that, come what may, they need to pay a dividend. When they can easily afford to do so, that is fine but, when they cannot or can only just manage, such a focus on dividends becomes unhealthy and can lead companies to make wrong choices.
As an example, there have been a number of businesses recently – most notably among the utilities and insurance sectors – that have experienced weakened capital positions and yet their management teams have refused to cancel their dividends even though they represent a significant imposition on the company and are plainly unsustainable as things stand.
These companies have instead chosen to go to the market and ask investors for extra funding through rights issues. As a strategy that makes no sense at all because it is effectively asking people for money so it can be returned to them in the form of dividends over the course of the next few years – minus, of course, the significant fees that will have gone the to investment banks working on the rights issues.
This is in part why, as income investors, it is incumbent on us to focus on more than just a business’s current dividend. We also need to consider its sustainability and the prospect of it growing over time and that can lead us to avoid some of the very highest dividend-paying companies in the market. When we do so, it is because ultimately we believe those dividends should not be being paid and the fact they are suggests some skewed priorities and unhealthy decision-making within the businesses.