19th May 2020

Dividends immune to Covid-19

Since the 2008 financial crisis and the implementation of non-conventional monetary policies around the world, bond yields have fallen significantly. The US 10-year yield, for example, has fallen below the dividend yield of the equities benchmark, the S&P 500. In Europe, many sovereign bond yields have even dipped into negative territory.

Dividend yields versus bond yields

Against this backdrop, many investors looking for yield have turned to equities, and specifically dividend-oriented strategies. Institutional investors such as pension funds and insurers have to meet yield requirements to cover their commitments. Retail investors are looking for yields above inflation since their number-one priority is to preserve capital.

Dividend distribution is just like a bond coupon payment, but it is more defensive and gives investors a stake in a company's capital.

Companies that pay dividends are generally more stable and well-established, and have a moderate growth rate. Conversely, those in a rapid growth phase tend to retain all profits and reinvest them to generate organic growth.

It should also be noted that companies that pay dividends theoretically use capital more efficiently (they tend to make more prudent investments). As a result, they are less inclined to falsify their books—when obliged to meet dividend payment requirements, it is much harder to manipulate financial reporting.

It should also be remembered that dividends are taxed, leading some investors to see them as a poor allocation of capital. However, the financial discipline required to pay regular dividends more than offsets this lower yield.

For companies, dividends are a way of sharing the wealth they create. Dividends convey a clear and powerful message about a company's future outlook and performance. Dividends are public promises. Reducing dividends can therefore be both embarrassing for a company's managers and harmful to its shareholders.

Since the beginning of this year and the spread of Covid-19 around the world, many companies have been forced to cut or cancel their dividends completely. The halt in economic activity and the lack of visibility, not to mention the pressure from governments in some cases, is forcing companies to preserve liquidity to shore up their balance sheets.

Traditionally, the most generous sectors in terms of dividend yield have been finance and energy. During this unprecedented period, it turns out that they are also among the most vulnerable. Companies whose dividend distributions to shareholders have been reduced so far this year include Royal Dutch Shell, Eni, Société Générale and Intesa San Paolo. The fall in dividends is also not limited to cyclical sectors. Even within traditionally defensive sectors, such as consumer staples, companies are reducing dividend distributions. Such companies include AB InBev and Heineken, the world’s two leading brewers.

That said, some companies are still able to pay out substantial dividends despite the difficult environment. They are effectively generating cash flow, and the luckiest are even able to take advantage of the crisis, affording them the possibility of raising their dividends.

 

Against this background, certain sectors and investment themes are excelling, such as health care, shipping and consumer non-discretionary.

What is more, dividends could become more attractive in the future, not only due to extremely low interest rates but also because companies have cut their use of share buyback plans. From 2017 to 2019, buybacks were the number one source of equity market support. However, most companies were forced to delve into their savings as a result of the economic crisis at the beginning of 2020, with their proportionately reduced cash flow inexorably leading to a fall in share buybacks. Without buybacks, growth on the equity markets may be hampered, making dividends an even more coveted source of yield.

With this in mind, the in-house Lux-Equity High Dividend fund is the ideal vehicle for investors looking for a dividend-oriented strategy. This fund features active management based on a fundamental economic approach. Economic forecasts are used to locate the current situation on the business-cycle curve. The portfolio is then adjusted, with changes mainly being made to the ratio between sectors that are sensitive to the economic cycle and those that are not.

 

Stock selection, mainly from European and North American stocks, is based on the S-GARP (Sustainable Growth At a Reasonable Price) approach, combining a number of stock selection practices such as growth and value styles. This method has been refined in order to focus on different companies' levels of fundamental and long-term growth. At this stage, special attention to debt and cash flows also ensures that companies in the portfolio or those that may be included pay sustainable and growing dividends.

Next, the weighting of the stocks is optimised using a quantitative strategy to achieve a portfolio with a higher dividend yield than traditional equity investments. As a result, the dividend yield of the Lux-Equity High Dividend fund is currently 3,7%—much higher than that of traditional benchmarks, whose yield is generally around 2% (see Charts 1 & 2).

The volatility that has shaken the financial markets over the past few months has also showcased the defensive nature of the dividend-oriented strategy. The fund reported volatility of 18,72%, which was well below that of the MSCI World equity index (27,2%).