Value Perspective Quarterly Letter – Q4 2021 - UK

In defence of the friendless.

We recently came across an article in the FT decrying the UK market as the land of income “dinosaurs”, full of “moribund” companies exhibiting “financial decadence” by having the temerity to pay a dividend. Long-term supporters of our funds will know we are not shy of a controversial opinion, but this article has, to be polite, somewhat overstepped the mark. This outlook is not an attempt to refute each point the article makes (to do so would be too churlish even for us) but is a defence of the UK market, it’s dividend credentials, and why we are optimistic on the UK’s prospects.

The first point to make is that many investors need an income. It is a statement of the obvious to say no matter where you look today, income is in short supply (chart 1).

To be clear, the above chart does not make a compelling case for equities (we’ll get to that in a minute) but it does frame the problem from a cross-asset class perspective; real yields are low irrespective of where we look.

Of course, within the equity space, there are some markets which stand out as more attractive than others. The UK is a clear standout, yielding more than its international competitors, with a greater than average differential (chart 2).

We can progress that argument by making the point that UK equities are not a singular monolithic opportunity, but a collection of stocks and sectors, some of which are more attractive than others. Today, there are six large sectors that yield more than their 25 year average (chart 3).

Our income based portfolios are understandably tilted very firmly towards the areas on the left of this chart. However, it is not just the income today that appeals, but the income growth potential of these areas. The FT article referenced at the start of this outlook piece suggests income growth is only delivered by companies with fast growing sales. This isn’t true.  Historically, a more successful avenue of dividend growth is to invest in companies that have recently cut their dividends but are returning to the dividend register.

Following a painful, but necessary, market-wide dividend cut in 2020, there are multiple avenues for dividend growth in the UK. The most obvious area is the UK banks, which were forced for regulatory reasons to cut their dividends to zero at the height of the pandemic, but have now been given the green light to resume dividend payments. Starting from a base of zero, the dividend growth is mathematically extremely high (technically it’s infinite, but we wouldn’t want to extrapolate that). Having traversed the difficulties of the first half of 2020, they have been given a clean bill of health by both their auditors and the regulator. They have sailed through two onerous Bank of England stress tests, and significant levels of excess capital remain. This has allowed each of the banks to reinstate a dividend, but also initiate share buy backs, which further increase ‘growth’ (at today’s valuations, the holy trinity of value per share, earnings per share and dividend per share all grow following a buyback).

Banks are not the only companies growing their dividends. At the peak of the pandemic the oil priced turned negative, prompting BP to half their quarterly dividend while Shell cut their dividend for the first time since World War 2 (their quarterly dividend was cut by two thirds). Both companies are large and consequently contribute significantly to the market’s overall income (or lack thereof). With a rebound in oil prices, and replenished balance sheets, both oil majors are now increasing dividends but also buying back their shares with excess capital (as per the banks, also growing value per share, earnings per share and dividends per share).

Dividend growth is not limited to these two sectors, but between them, banks and oil & gas account for 15.4% of the UK market and provide a narrative around dividend growth for those who prefer stories to numbers. For those that prefer numbers, following the market wide dividend cut of 2009, the UK market compounded dividends at 7.5% per annum for a decade as companies came back to the register and the economy rebounded from the effects of the GFC (Global Financial Crisis). This level of growth does not look implausible from today, as companies once again return to the dividend register and the economy rebounds from the effects of the pandemic.

To move away from the theoretical, our flagship Income product increased it’s interim dividend by 100% between August 2020 and August 2021, a level we wouldn’t want to extrapolate going forwards, but it does demonstrate that dividend growth doesn’t just exist within a theoretical spreadsheet, and isn’t the sole preserve of companies owned by growth investors.

It is an easy, but incorrect, argument to say the big UK dividend payers are dinosaurs that can’t grow and don’t change. The market environment, the income, and the opportunities within it are constantly changing. Charts 4, 5 and 6 show the biggest dividend payers when I was born, when I started in the City, and today.

This hopefully puts to bed the idea that the UK market is fossilised, or that dividends in some way limit the dynamism of the market. The market is constantly changing, the income payers constantly are changing, and the opportunities are constantly changing.

At this point, we should highlight that even our non-income based portfolios are tilted towards the sectors which have higher yields than average (the left hand side of chart 3). Why would that be? Because over time, where income goes, capital follows.

At its simplest, real total returns can be disaggregated into two items; a fundamental return (a combination of earnings growth once adjusted for inflation and reinvested income) and revaluation.

When we are analysing market performance, and particularly when we (or FT contributors) are drawing conclusions about a market, we need to assess whether performance has been driven by fundamentals or revaluation. Why? Because when viewed over short-time periods, revaluation can dominate and this potentially leads to erroneous conclusions. However, over time, when viewed at a market level, the scope for revaluation is zero. Fundamental growth can be repeated, revaluation upwards (or downwards) cannot. This disaggregation allows us to analyse the performance of the UK and take a view on its prospects (chart 7).

What we can see from the clustering of red bars on chart 7 is that periods of upward revaluation are often followed by periods of revaluation downwards. And vice versa. This is why revaluation should not be extrapolated over time. Having had a recent period of downward revaluation, and trading at a significant discount to other global markets (both on an unadjusted and sector neutral basis) it is not inconceivable the UK might be revalued upwards over the medium term.

And what of fundamental returns?  While they are significantly more stable than market returns, good times are still followed by bad times, which are followed by better times (and so on). The fundamental return of the UK market has averaged just over 5% real per annum over the past 70 years, a level of return we would forecast for the UK if making a naïve forecast. However, we can improve on that by reflecting some of the ‘inside-view’. Recent fundamental returns have fallen slightly shy of the long-term average, in part dragged lower by the self-imposed difficulties of PPI on the banking sector and the dividend cuts discussed above. Unless we expect a repeat of PPI, or of dividend cuts, an improved level of fundamental growth from here would be a reasonable expectation.

Ironically for an article exhorting us to focus on the future, the FT contributor’s view of the UK is based on performance over the past decade; but as we all know, past performance may not be repeated. When our more positive view on fundamentals is compounded with the potential for revaluation, it leads to a significantly more optimistic outlook for the UK. Over the medium term, the UK has the potential to surprise positively, to be one of the strongest global markets from an income perspective, to be one of the strongest global markets from a capital perspective, to demonstrate its health, and to thrive.

*Any view of the future should always come with a disclaimer. In the near-term the covid pandemic continues and we must acknowledge the potential for new variants of the disease to arise, noting the impact that they could have on government policies, economic activity and corporate cash flows. We are protected to an extent by the strong balance sheets and low valuations of the companies that we own, but the risk remains and as investors we remain conscious of the potential impact when analysing all potential investments.

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