21st February 2011

Schroders – Hidden dividends

A focus on dividend yield has proved to be a successful method of generating exceptional returns for investors, both over time and across most regions globally. We are confident a high-yield strategy can continue to outperform over the medium term but would highlight some unique factors to this cycle, which means investors need to tread carefully.

Of course, the phrase “this time it’s different” always needs to be taken with a pinch of salt. Nevertheless, the debt-fuelled credit crunch has provoked a unique set of circumstances and combined with the concentration of yield in the UK index, there are some unique consequences that need to be considered when investing. 

However, before considering the current situation, it is important to understand how the outperformance of a dividend yield investment strategy is generated.  Most people would naturally assume the majority of total return from a yield-focused approach comes from dividends. But academic studies show the return is broadly even between the income those stocks generate and their capital growth.

While the income element of this return is relatively easy to understand – the approach majors on companies that pay dividends - the capital growth side needs greater explanation. Companies that fall on hard times, for whatever reason, resist cutting their dividend. The stigma associated with cutting dividends is high and companies attempt to maintain payments even as profits decline.  This can be evidenced by the market dividend not declining during the severe recessions of the 1980s, 1990s and post the technology bubble, despite a severe fall in profits.

An approach that focuses on the dividend rather than the current depressed profits has historically proved to be a basic recovery strategy – the static dividend gives a signal to the market of where the management believe the struggling company’s profits can return to.

As the corporate environment improves, profitability increases until the dividend can once again be paid out by profits. It is this improvement in profits that drives the proportion of total return that does not come from dividends. The yield investor holds the stock while profits recover and the stock market increases its view on what the company is worth. Both the income and this improvement in profits/valuation are crucial to the total return of an income investor.

To emphasise this, a high-yield strategy would not have outperformed relying solely on the dividend - the capital return from improving profits and valuation is equally important. And so we turn to the current environment. Is this time different?

During 2008 and 2009, the cost of financing from banks reached such extreme levels that when offered a choice of paying a dividend out of debt or not paying one at all, many companies chose to reduce or cancel distributions. This led to the first market-wide dividend cut in the UK for decades. Companies that would have traditionally maintained their dividend as a flag of profit potential were forced to cut them to zero. This clearly does not mean that potential profits are now zero but is merely a function of the environment of 2007-2009. For us, such a background requires a more nuanced and pragmatic dividend strategy in order to repeat traditional outperformance.

There are areas of the UK market that managed to hold (or even grow) their dividend. These are the more defensive areas where profits did not come under pressure, such as utilities, tobacco companies, or beverages.

While the yield on some of these companies is superficially attractive, it is difficult to see them fulfilling the capital growth proportion of required return, as their profits never really declined, and sentiment remained favourable toward those companies throughout the period. We have always viewed the dividend as a company’s ‘hidden’ profit potential - the company’s own view on the sustainable long-term profitability of their business.

The current challenge for income investors is that due to the events of 2007-2009 it is not only profits that are hidden, but unlike in previous recessions, also the dividend itself. To generate the historic level of (total) returns an income strategy provides, investors need to be able to benefit from the improvement in profits and valuation. In today’s market, following the events of the past two years, that generally means investing in companies that pay a nominal, or even zero, dividend.

Simply buying the highest-yielding companies is unlikely to provide historic levels of outperformance, as that strategy will miss out on the capital gains generated from improving profits and valuation that is so important for an income style. The domestic banks are an obvious sector where payouts are either low or non-existent, which means they currently lack a signal for what profits, or indeed dividend, will look like coming out of recession.

This makes income based analysis more difficult than in prior recessions - but not impossible. Our work has always majored on the long-term profit potential of every business we invest in. It is only when we have a view on profits, that we can form a view on the dividend. This focus ensures that we always consider both elements of total return, placing no undue emphasis on income to the detriment of capital, or vice versa.

This has led us to invest in a number of companies that provide no income today but will over time as profits improve. They say that time heals all wounds. The same is true for the banks, as well as other beaten-down areas such as retailers and housebuilders. Lloyds TSB is expected to reinstate its distribution for the 2011 financial year, and many retailers and insurance stocks are already returning to the dividend register as their earnings gradually improve. Profits will grow and dividends will return.

The challenge this market sets income investors is to deliver the returns their investors expect by capturing the capital gain. A gain that will potentially occur before the company formally announces its return to the dividend register.

Kevin Murphy

16 February 2011

Important Information:

The views and opinions contained herein are those of Kevin Murphy, Specialist Value Fund Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.

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