In 2015, UK companies paid out £80bn in ordinary dividends and an additional £5.6bn in special dividends – an annual increase of 8% versus an average 2% per annum real growth since 1960. By the end of 2016, UK companies will have paid shareholders over £1 trillion in dividends since the turn of the century.
However, dig a little deeper, and the sustainability of UK dividends is being increasingly tested. A total of £5.7bn of dividends was cut by FTSE 100 companies during 2015, UK dividend cover (the ratio of a company’s net profits to its ordinary dividends) is at its lowest level since the early-1990s recession, and 33% of all UK dividends in 2015 were paid by just five companies (BP, Shell, HSBC, GlaxoSmithKline and Vodafone), each with their own dividend concerns. So, not only is the payout ratio high, but the market’s high yield is increasingly attributable to relatively few companies. As a result, the Capita Dividend Monitor is forecasting that 2016 will see the first annual decline in the value of UK ordinary dividends since 2010.
Why does this matter?
- Dividends provide the vast bulk of long-term returns from equities. The FTSE All-Share Index has risen by 17.6% in capital terms over the last ten years – an average of 1.6% per annum, compared to inflation of 2.3% (so a real loss of -0.7%). However, with the help of the UK’s above-average dividend yield, the FTSE All-Share has produced a 68% total shareholder return, taking into account dividends and the reinvestment of dividends.
- The current headline FTSE All-Share dividend yield of 3.9% has become an increasingly important source of income in the current deflationary environment. It compares to a redemption yield of 1.9% on 10-year gilts, and a dividend yield of 1.9% on the MSCI World Index.
- Many high-profile dividend cuts in 2015 resulted in significant share-price underperformance – think Standard Chartered, Centrica, Glencore or Tesco for instance.
So we continue to be wary of optically high UK dividend yields.
Royal Dutch Shell, for example, is investors’ largest source of dividend from the FTSE 100 Index, and is expected to be responsible for £1 in every £7.50 paid out in 2016 (compared to £1 in every £10 in 2015). The company currently yields 7.2% and hasn’t cut its dividend since 1945. Following the sharp fall in the oil price, this dividend is currently substantially unfunded by cash flow, with the company relying instead on $70 billion of debt, $30 billion of asset disposals (sold at the bottom of the cycle) and scrip dividends (issuing equity at the bottom of the cycle, and thereby diluting shareholders) to plug the gap, all of which appear detrimental to long-term equity investors.
What are we doing about it?
In managing the Newton UK Income Fund, we continue to be biased towards business models with a high return on invested capital through the economic cycle, strong balance sheets, proven management teams and sustainable dividends. It is the future cash flows and the price paid for these cash flows, not the level of dividend, which matter most to us. As a result, we continue largely to avoid the highest-yielding sectors, such as oil & gas and financials, where we see increasing distress despite optically attractive headline yields. Instead, our greatest overweights are in health care (which offers structural growth), media & software (high recurring revenue, and minimal capital requirements), and utilities (foreseeable and consistent levels of cash flow).
 Returns sourced from Bloomberg, 15/06/2016, ten years to 05/31/2016