CPD: The enduring allure and sustainability of dividends

The recent economic downturn caused by the COVID-19 pandemic provides another example of the resiliency of dividends. As in the past, they held up better than earnings, with the most severe pressure in specific sectors. This article from equity income specialists Epoch Investment Partners, discusses the importance of dividends to any prudent capital allocation policy.

Where will income come from? Pension funds and retirees alike are asking this question as they seek to grow their assets and fund future liabilities. Unorthodox monetary policies have suppressed bond yields and sharply diminished what was once the cornerstone of income generation.

Dividends from equities, however, have remained relatively consistent. Of the three components of equity market returns—dividends, earnings growth (a proxy for free cash flow growth) and valuation multiples—only dividends cannot turn negative; they have been a stabilising factor for returns every year, going back as far as reliable data exists.

Today, equity market yields provide substantially more income than sovereign bond markets in the developed world, where in most cases real yields are negative. If we narrow the equity universe to companies that emphasise paying dividends, yields there are well in excess of those for investment-grade credit. For example, the effective yield for the ICE BofA BBB US Corporate Index was only 2.15% at the end of November (Source: Federal Reserve Bank of St. Louis).

The sustainability of dividends has been tested through panics, manias, wars and recessions. The COVID-19 pandemic and the recession it triggered provide us with a recent example of their durability.

The reports of my death are greatly exaggerated

Those words were in a cable from Mark Twain to the US press after his obituary was mistakenly published. Similarly, narratives on the “death of dividends” have been proven premature over and over, including in our recent COVID-19 experience.

In March 2020, the abrupt decline in revenues, earnings and cash flows raised questions about the capacity for businesses to continue with shareholder distribution practices. There was also heightened political pressure on companies to reduce or restrict shareholder distributions temporarily. In some cases, companies that declared dividends along with annual results earlier in the year cancelled or reduced those dividends in response to public pressure—even though in many cases they continue to remain viable businesses with ongoing cash flow that would support dividend payments as announced.

Despite all this, dividends held up well for several reasons. First, dividends are an important part of any sound capital allocation policy. If a company cannot earn a return that is above its cost of capital on capital reinvestment, then it should return excess cash to the owners of the business through dividends or some other form of shareholder yield.

Second, while companies certainly tighten their wallets in recessions, that does not necessarily put dividends at a high risk. In recessions, dividends tend to be more stable and go down less than earnings in the aggregate, as companies will often maintain payouts during episodes of earnings compression. Share buybacks are more likely to be cut in these environments, often acting as a shock absorber. S&P 500 dividends usually track earnings, but during recessions fall by about half as much. This is illustrated in figure one.

Third, earnings and dividend pressures in economic downturns tend to be concentrated in a few industries. These include energy, financials and consumer discretionary as shown in figure two.

Furthermore, these pressures vary widely among companies within each sector, highlighting a benefit of active management in seeking to avoid companies where the dividend could be at risk. By way of example, the positioning of the Epoch Global Equity Shareholder Yield strategy in energy, financials, consumer discretionary, consumer staples and healthcare is summarised as follows^[1].

Putting it all together

We have confidence in the resilience of dividends. Free cash flow coverage of the dividend is one key metric to help determine whether a company can sustain its dividend. While this metric will vary by sector, we like to see at least 1x and ideally 1.5x or greater at the portfolio level.

Another source of confidence in the sustainability of the dividends is based on the current trailing and forward free cash flow growth rates of the portfolio. As of September 30, the trailing free-cash-flow growth of the Global Equity Shareholder Yield strategy was 9.8%* for the past five years and 6.1%* for the past three years. The dividend yield of the portfolio was 4.1%^[2].

The Global Equity Shareholder Yield strategy has historically achieved a high level of income by assembling a diversified portfolio of high-quality companies that generate sustainable free cash flow and consistently return excess cash to shareholders in the form of dividends. It is diversified not only across sectors and countries but also by contributors to dividend yield and growth. The holdings tend to be global champions with dominant industry positions and the ability to grow free cash flow in both challenging and strong market environments. We can see in the chart below that the strategy’s income has held up remarkably well, especially when compared to bonds.

Epoch’s team has been tracking the number of companies that increase their dividends since 2008. From 2008-2019 we have seen a range of 62-88 companies increase their dividends on an annual basis for an average of 77 per year. The data is provided in figure four.

It has been a challenging period on many fronts. A majority of our portfolio holdings, however, have maintained cash on their balance sheets and continued to generate the cash flow necessary to sustain and grow their dividends. And they are unlikely to abandon sound capital allocation policies as they manage through the effect of the pandemic on their businesses.

Importantly, advisers and investors that want to focus on companies paying high dividends need to pay attention to whether those dividends are sustainable, and whether they can be increased over time. A share portfolio comprised of companies paying a sustainable and growing dividend will be better positioned to ride out challenges in the years ahead.

————

[1] Securities highlighted or discussed in this section have been selected to illustrate our investment approach and are not intended to represent the strategies performance or be an indicator for how the strategy has performed or may perform in the future. Each security discussed in this section has been selected solely for this purpose and has not been selected on the basis of performance or any performance-related criteria.
[2] Source: Epoch Investment Partners

Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2021 Epoch Investment Partners, Inc.