Cast your mind back to 2019. In many ways it was a simpler time – no one had ever heard of a ‘lockdown’ (maybe a lock-in, but that was something quite different). And I had a cuddly and chilled one-year-old rather than an argumentative six-year-old (*memories may prove inaccurate*).
It was also a simpler time to be running UK income funds – UK dividend payments had hit near-historic highs, breaking through the £100bn barrier. Many UK companies had long dividend histories that they were keen to preserve.
UK dividends collapsed 42% in 2020, far beyond what we ever modelled as a ‘worst case’ scenario.
Fast-forward to the present day. Even now, UK dividends remain 10% below where they were in 2019. The cause, of course, was Covid-19.
The pandemic’s impact had a profound effect on companies’ cash positions. Many businesses in the most affected sectors – including tourism, hospitality, aviation and retail – were forced to cut their dividend payments dramatically or even suspend them entirely. Banks were forced by their regulator to stop issuing payouts for several months. Some companies took a lot longer. Retail giant Marks & Spencer did not pay a post-Covid dividend until last November.
Why then, if dividends remain down from pre-pandemic levels, am I more optimistic about the prospects for UK income?
A useful re-set
The reality is that many businesses were overdistributing before Covid. Many had long dividend track records that they were loath to lose, so there was a tendency to keep paying the dividend even if, with a fresh sheet of paper, it should have been lower.
Those long track records are now often lost, so boards have the freedom to decide what the ideal dividend payout ratio is. In the past, there was a tendency to let ratios persist or drift up even in the face of a decline in earnings, but this approach is now much rarer.
Companies are showing encouraging discipline. We see this most clearly in companies whose earnings are naturally volatile. For example, in late 2023, in light of lower commodity prices, London-headquartered mining multinational Anglo American’s interim dividend was down almost 50% year-over-year.
The phenomenon can also be found elsewhere. Take building materials specialist Marshalls, which recently responded to a fall in earnings by reducing its interim dividend by around 50%.
Reasons to be cheerful
A less rigid dividend policy gives companies more flexibility to deploy their cash in other ways. They may channel it into capital expenditure – an area where the UK has usually invested less than comparable economies. They may use it to pay down debt or finance share buybacks.
It also offers a more realistic prospect of future dividend growth. By way of illustration, imagine a company that has a long dividend history but the pay-out ratio has drifted up over time, with dividend growth outpacing earnings growth and the pay-out ratio reaching 65% of earnings (the UK market as a whole was not far off this in 2019).
What would happen if this business’ earnings were to go up by 10%? There is every chance the board would decide to ‘grow back into’ the dividend by keeping the dividend-per-share flat.
By contrast, imagine a company with a payout ratio of 30% that enjoys the same rise in earnings. In this case there would be a decent chance that the dividend, too, would go up by 10%.
Income implications
Naturally, a dividend landscape in which flexibility is more common might present a forecasting headache for income funds. Specifically, it is likely to make life trickier for funds that distribute 100% of their earnings.
For many investment trusts this is not a problem. It might even be seen as an opportunity. Revenue and capital reserves allow us to smooth dividends over time – as happened during Covid, when the funds I co-manage did not need to cut dividends at the trust level.
So, for investors seeking predictable income from UK companies, particularly in an age of greater dividend flexibility, I would argue that investment trusts should be a consideration.
It was the Covid lockdown era that forced companies to reappraise their dividend policies. That, combined with the deep discounts currently available on UK equities, has created outstanding opportunities for income-focused managers to buy strong UK companies paying sustainable and growing dividends at attractive prices. I believe it could pay smart income-focused investors to lock in these bargains while they last.
Laura Foll is co-manager of the Henderson Opportunities Trust, Law Debenture and Lowland Investment Company. The views expressed above should not be taken as investment advice.