Companies like Vodafone can now afford to double their yield. When asked to do so at a recent meeting, they did not reject the idea as they would have in the past
The past three years have been a torrid time for UK investors after the FTSE All-Share Index peaked in September 2000. The period leading up to this, encompassing the technology boom, had been both an exciting and rewarding time for investors. Since then equity investors have experienced the heaviest losses for a generation which, at their lowest point, saw share prices fall to half peak levels.
It is unsurprising in such market conditions investors sought a higher level of security and lower volatility than the market as a whole. Some have found it by excluding equities entirely and buying bonds. Others have stayed with equities but sought to reduce their risk by buying higher yielding equities.
In volatile times, the security of a regular cash dividend payment was worth more than the prospect of uncertain capital returns and hence higher yielding shares enjoyed a relative re-rating.
The more predictable and generally slower growing earnings of higher yielding shares certainly lagged the more exciting sectors during the latter stages of the bull market, but this portion was reversed during the subsequent bear market. From its peak in early September 2000 the FTSE All-Share Index was, despite the bounce experienced since March, still down 39.6% as at 4 July.
The FTSE 350 Higher Yield Index by comparison was down by only 19.6%. On a total return basis, with dividends re-invested, the FTSE All-Share Index has fallen by 34.4%, compared to only 10.5% from the FTSE 350 Higher Yield Index over the same period.
During the bull market investors were more attracted by the prospects of seemingly easy to achieve capital gains. They forgot the disciplines of taking dividends as part of the total return from equity investment. Of course, during the subsequent bear market perceptions have changed and the importance of dividends has again been realised.
Investing for income is not without risk, returns have still been negative over the last three years. In some cases dividends have been cut as profits and, hence the cashflows needed to pay dividends, have come under pressure.Within the FTSE 100, stocks as diverse as Scottish Power, Reuters, Arriva, Scottish & Newcastle and Abbey National have all announced reductions in dividend payments. Prudential, the insurance company, seems very likely to follow this trend in their forthcoming interim results.
In difficult economic conditions it is inevitable that for many companies, profits will come under pressure. Those that have strong balance sheets and relatively high levels of dividend cover are able to sustain payments until conditions improve, but for those less fortunate, or prudent, the outcome has been more difficult.
Despite the problems some companies have been experiencing, many have continued to thrive and grow both profits and dividends. The housebuilding sector is a good example. The doubling of short-term interest rates between 1988 and 1990 led to a rapid turnaround in the housing market from boom to bust. Many housebuilders carrying high levels of debt experienced some difficulties. Profits turned to losses and balance sheets weakened with the result that many companies had to raise new equity, at depressed levels, in order to survive.
Dividends, understandably, became a luxury that many could not afford. What is important today is that the hard lessons of this cycle have not been forgotten. Within this sector balance sheets are in much better shape with lower levels of gearing. Also, levels of dividend cover are much higher as a lower proportion of cashflow is paid to shareholders.
This may seem over cautious just now when trading conditions are strong, but when the next downturn comes, as it inevitably will in this cyclical sector, dividends will prove to be more secure and sustainable than in the past. For income investors this is important as a steady growth in dividends is preferable to higher growth followed by a cut.
The tobacco sector has consistently been able to grow dividends, reflecting the strong cashflows from this industry. It is also one of the few industries where companies have been able to make acquisitions which can quickly, and demonstrably, generate value for shareholders. Two companies within this sector, Imperial Tobacco and Gallaher, have both made significant acquisitions in Europe in recent years. The recent depreciation of sterling against the euro is therefore giving a boost to their profits and cashflows, hence supporting dividend payments.
However, exchange rate movements have not all been beneficial for UK companies recently. At the same time as it has depreciated against the euro, sterling has strengthened against the US dollar. In recent years more UK listed companies have been both preparing their accounts and paying dividends denominated in this currency. Some of the very largest UK companies including BP and HSBC pay dollar dividends. In 2002 high oil prices boosted the earnings of BP and this was reflected in a 9% increase in the dividend, but for UK investors the strong pound versus the dollar resulted in only a very modest increase.
It is important to put all this into perspective however, for despite some high profile cuts and the impact of currency movements, the aggregate level of dividend payments from UK companies is being maintained. There will be very little growth in 2003, but looking forward investors can expect dividends to rise by slightly more than the rate of inflation. As more industries mature and experience slower growth, others are just moving into a phase when cash generation becomes strong.
Three years ago Vodafone was leading the UK stockmarket upward and was for a time the largest company by market capitalisation. Mobile telephony was growing fast and all available cash was utilised for investment into new network capacity and acquisitions. Many of the latter have proven to be overpriced, but as the industry matures strong companies, such as Vodafone, are now generating significant amounts of cash.
They are now growing the dividend faster than earnings but I believe they can do much more. At a recent meeting with the company the finance director asked what we as shareholders wanted from the company. My response was to ask that, for a starter, the dividend should be immediately doubled, and this was not immediately rejected as it would have been even a year ago.
Whether the management likes it or not, Vodafone is maturing and hence this stock will become of increased interest to fund managers seeking income in the future.
The economic background is currently relatively unexciting. Growth in GDP remains below trend across the world's largest economies and the UK is not immune from this, despite the boost from the growth in public expenditure. In the first quarter of 2003 the UK economy grew by only 0.1% as the momentum of the consumer sector slowed.
For a UK investor seeking income currently, the prospects from either cash or gilts are not very compelling. Gilts with a maturity of ten years currently offer a yield of only 4.2% and cash deposit rates are even lower. A portfolio of higher yielding shares, can often offer significantly more than this. In addition to higher levels of initial yield, investors have the knowledge that the dividend has grown every year for the last 20 years. Current revenue estimates look comfortable and should ensure that their trend can be continued.
Dividends have grown for the past 20 years and they should continue to do so.
The bear market since 2000 has made dividends seem more important to investors.
The strength of the euro and weakness of the dollar has impacted the levels of dividends from companies with global exposure.
Many companies formerly focused on capital growth are now in a position to pay dividends.
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