Home Latest News Is The Turning Of The Dividend Cycle Necessarily A Bad Thing For Investors?

Is The Turning Of The Dividend Cycle Necessarily A Bad Thing For Investors?

by Paul

This year the dividends paid out by London-listed companies is set to reach a record £107 billion. Yes, the total is flattered by the fall in the value of the pound, with the exchange rate accounting for a whole half of increases, and a run of particularly large special dividends. But those investing online in income stocks will be quietly satisfied nonetheless.

But analysts have already warned investors not to get used to dividends growth. With currency influences stripped out, 2019’s underlying dividends growth rate is a relatively modest 2.9%. And a long list of companies warning that dividends will now or may have to be cut in the near future is forming. Vodafone, BT, SSE and the Royal Mail are all on it and Centrica, another utility, announced this week that it will do so with immediate and brutal effect. Its investors will receive less than half the dividend they had been expecting.

But should investors necessarily accept the companies they hold shares in scaling back dividend payouts as a negative?

Which Companies Are Traditionally Strong Dividend Payers?

Companies which are traditionally strong dividend payers are typically large, established companies in established markets. Neither the companies nor the markets they operate in are usually particularly dynamic and they would have a strong, relatively stable market share. The share of revenues directed towards growth, either organic or through acquisitions, is generally a lot lower than would be the case for ‘growth’ companies.

The result is companies that generate strong cash flow and solid profits but lack an obviously strong growth trajectory. Investors can’t be enticed by the promise that quickly growing revenues or market share will provide a return by driving share prices up. So they instead attract them into the stock by providing an income in the shape of dividends. That’s why shares in this kind of company are often referred to by investors as ‘income stocks’.

Companies whose shares are considered ‘income stocks’ can, and do, come from a wide range of sectors. However, there are a handful that are most associated with income stocks, such as the traditional banking sector, utilities, energy, natural resources, REITs and contract manufacturing.

Because these companies rely on dividends to keep their shares attractive to investors, maintaining their market capitalisation, they rarely cut them and often go through sustained periods of raising them. As such they are generally considered low risk investments and are particularly popular with small retail investors – especially those who are already retired or approaching retirement and want to draw an income from their investment portfolio.

So Why Are So Many UK Income Stocks Cutting Dividends Now?

British companies that have already announced dividend cuts include M&S and Vodafone. Both have been among the most consistent dividend payers on the London Stock Exchange. Vodafone is cutting its dividend for the first time ever and M&S has only done so on three occasions over its 134-year history. So why now?

One of the major reasons why so many historically reliable dividend payers are now beginning to cut back is because the market environment in which they operate is no longer as stable as it once was. Technology is now disrupting almost every sector and industry and those that had escaped the revolution until now are quickly finding themselves in a quickly changing marketplace they are ill-equipped to adapt to.

M&S is a case in point. While online retail is not a brand new phenomenon its market share has reached tipping over the past few years. The evidence of that can be seen in the number of traditional UK bricks and mortar retailers that have failed or run into serious trouble over the past couple of years. Debenhams, House of Fraser, Philip Green’s Arcadia Group that includes TopShop, Miss Selfridge and Dorothy Perkins and Homebase are just some of the names on that list. The rise of the Amazon juggernaut

M&S has been in steady decline for a while but the success of its grocery shops and ready meals offering helped paper over the cracks of its clothing and home retail performance. The customer base of the latter is also a largely older demographic less inclined to shop online. But as a more tech-savvy generation has entered that demographic, M&S has also belatedly felt the fuller impact of the trend towards ecommerce. That and the fact several attempts to reinvigorate its fashion lines to appeal to younger generations have met with limited success.

Vodafone’s case is very different but also intrinsically tied to technology advances. The telecoms company faces a huge bill to upgrade its network for the roll-out of 5G high-speed mobile internet. It’s finding the cashflow to do so in large part through its unprecedented dividend cut.

Even traditional utilities such as Centrica are being affected by technology and other market changes such as legislation and regulation opening up a market that was once viewed as a natural monopoly to competition. On the technology side, utilities are having to make large investments in ‘smart’ connected technology to make energy infrastructure and usage more efficient.

Terrestrial television channels such as the BBC and ITV, a publically listed company, are also having to invest in changing their business models as streaming services and on-demand technology erode traditional audiences and advertising revenue streams.

The traditional banking sector is having to invest huge sums in bringing their digital infrastructure and client-facing services up to scratch. Online-only banks, which have had the advantage of building their digital presence from the ground up and not over the top of hulking, fractured legacy systems like traditional banks, have so far only nibbled at the sides of the market share of traditional banks. But with hundreds of millions in private equity and venture capital now flowing into digital pretenders, the traditional sector is gradually waking up to the threat and investing. They are going through an expensive digital transformation that encompasses their back-office infrastructure, the plumbing that connects them to the international banking sector and their client-facing digital presence.

While the impact in different industries varies, technology changes are threatening the traditional stability in market share, revenues and profits of most income stocks in one way or another.

Cutting Dividends Is Often The Right Move

While many investors, private and institutional, large and small, will gnash their teeth and bemoan dividend cuts by the companies they hold what they thought were income stocks in, the reality is many should have done so sooner. In a changing world big, traditional companies are no longer safe. If they don’t invest to evolve and grow, they will be quickly overtaken by younger, smaller and nimbler competitors – often making better use of technology.

Investors should be more worried about their exposure to companies who are stubbornly burying their heads in the sand and hoping that continuing to pay the same, or raise, dividends will keep investors onside. That might work in the short term but failing to invest will eventually see both companies and their investors lose out.

Of course, cutting dividends and investing is no guarantee to the future prospects. In the case of some income stocks, the companies may have already acted too late to make the kind of investments they need to continue to survive and then flourish again. Or lack the leadership and culture to choose the right investments and execute well enough for them to have the desired effect.

But reinvesting cash flow evolving a company is at least a step in the right direction. For investors seeing their income fall as dividends dry up, the judgement call is whether they back the company to invest wisely, replace them with stocks still paying the kind of dividends they are looking for and they believe will continue to do so, reallocate investment capital to fixed income investments or change investment strategy altogether to pursue growth.

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