Where next for income?
6 July 2020
Charles Luke, senior investment director, UK Equities, Aberdeen Standard Investments, considers income investing during the current pandemic and what is affecting the market outlook
This article was originally published in the July/August issue of professional paraplanner.
The coronavirus crisis is affecting almost every aspect of daily life; changing the way we work and socialise for the foreseeable future. Its effects on businesses, economic growth and financial markets are similarly far-reaching. We find ourselves in completely unchartered waters and with an extremely opaque outlook.
Some of the earliest financial consequences of the pandemic have come through in company dividends. At time of writing 441 constituents of the FTSE 100 have cancelled, cut or suspended their dividend payments. Tourism, hospitality, aviation and retail have been some of the hardest hit sectors. But even major UK bellwethers like Shell, previously associated with dividend security, have not been immune.
Clearly, it’s not just balance sheet weakness behind this – politics and public relations are also at play. As a quid-pro-quo for government assistance during the pandemic, some companies are refraining from paying dividends and thereby avoiding negative PR. There are regulatory pressures too. The UK’s largest banks and insurers have cancelled payments following pressure from the Prudential Regulation Authority. Such action should helping them retain capital for increased provisioning and post-Covid-crisis lending. For other businesses though, it’s about taking a cautious approach and preserving cash when the economic outlook remains so uncertain. With a global recession already in train, and no way of knowing how long or severe it may be, this seems a sensible precaution.
Impact on income investing
As a UK income investment manager, this dividend backdrop is particularly challenging. At times like these, there is often the temptation to churn the portfolio and react to every piece of newsflow and every ‘noise’. Then there’s the ‘siren call’ of investing in lower-quality companies with better near-term dividend yields. These approaches seldom work.
What can work through a crisis though is maintaining quality income strategy; focusing on dependable high-quality companies with strong balance sheets. These firms are well placed to continue to grow their business, reinvest in it, perhaps partake in M&A, and grow their earnings year on year. And they are more likely to be able to pay dividends, even when conditions change. Companies with compelling long-term structural growth stories, perhaps with global brands or valuable intellectual property, are attractive too. There is a good chance that the strong will emerge stronger from the crisis.
Then there’s diversification. The pandemic has and will continue to affect different companies and sectors in different ways and at different times. As always, it makes sense to be well diversified and not overly dependent on any one economic scenario, sector or company. Dispersion across mid-cap and large-cap stocks can be a good idea too, as can exposure to other types of independent income streams, such as writing options.
Finally, know your companies. The pandemic has exacerbated and accelerated existing problems within many businesses, so right now, company fundamentals matter more than ever. A company with the right business model, in the right industry, with solid management and a strong balance sheet will always be better equipped to overcome the challenges that come to all businesses over time.
So what of the market outlook from here? As we stand today, only time will tell if prices currently reflect the risks but I’m not optimistic about a v-shaped recovery. I expect we will be in a world of low growth, low inflation, high debt, high unemployment and weak demand for a long time.
In some sectors, particularly travel and leisure, valuations look cheap. However, it’s difficult to have any confidence in what will happen next, when the outlook is dependent on so many unknowns. Will we find effective treatments for the coronavirus and a vaccine? What will be the long-term impact of social distancing on businesses? How will consumer behaviour change?
Finally, we’ve seen companies come to the market to raise capital of up to 20% of their shares through placings. We’ve yet to see rights issues for greater amounts, but that will come. We’ll see more companies raising larger amounts, which will probably make valuations look less attractive.
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