Finding equity investment income during the effects of the pandemic
Covid-19 has had a profound effect on the everyday lives of billions of people around the globe. Stringent lockdown measures have been imposed across the world to prevent healthcare systems from being overwhelmed which are only now being eased. These measures have been successful in their primary aim but have come at a severe economic cost as large areas of economic activity have simply ceased.
Shops were shut, restaurants and bars were closed, international travel and tourism have collapsed, and construction and manufacturing have faced severe operating difficulties. Whilst lockdown measures are now beginning to be relaxed the economic damage is already apparent with unemployment even now beginning to rise sharply.
Charities will also be challenged by the crisis. Demands for benevolence are likely to rise in the recessionary conditions brought about by the lockdown at the same time as donations are under pressure and investment income is falling. Of particular concern is the outlook for dividends from UK investments, especially for permanently endowed charities which cannot spend capital.
Cash conservation measures
In the UK, companies have responded to the crisis by implementing extreme cash conservation measures to protect their balance sheets, which, in many cases, has meant the suspension of ordinary dividend payments to their shareholders. Around half of the FTSE 350 Index of large UK companies have suspended payments or announced significant reductions.
Notable income casualties have included the entire banking sector (where the industry’s regulator, the Prudential Regulation Authority, instructed all banks to cease paying dividends), well known high street names, such as Marks & Spencer, Next and Sainsbury’s, and Royal Dutch Shell, which cut its dividend for the first time since the Second World War as the oil price fell to under $20 per barrel.
Even companies with strong balance sheets and whose trading has been relatively unaffected by the virus have chosen to defer payments because of the uncertainty. At present it appears that dividends from listed UK companies could fall by around 40% in 2020.
Traditionally, the UK has been amongst the highest yielding of developed world stock markets but even this level of reduction would still leave it yielding more than its international peers. However, such an outcome will have a severe impact on charities which depend on UK equities for investment income. Charities are now facing very difficult decisions about whether to reduce spending on their charitable aims, cut operating costs or dip into reserves (if they have any).
Distancing undermines economic activity
At the outset of the pandemic it seemed possible that the economic recovery could be swift once lockdown measures had succeeded in controlling the spread of the virus, but it now seems likely that some sort of social distancing will be with us for the foreseeable future in order to prevent the infection rate (or R number) climbing back above 1 and signalling a second wave of infections. Any form of social distancing makes a great deal of economic activity difficult and potentially unprofitable.
Consider the restaurant trade. If restaurants are forced to reduce the number of covers to enable adequate distancing, then the only way to re-attain previous levels of revenue would be to increase prices – hardly a recipe for filling even the reduced number of tables. Or in general retail how many potential customers will simply walk past a shop if there is a long queue outside. How many will bother queuing at all if it is raining? How many consumers will take a cautious approach to returning to the shops?
These effects will be detrimental to economic activity even before considering the effect on discretionary spending caused by rising unemployment and the fear of losing your job. In April alone there were 850,000 new unemployment claimants in the UK. There are many millions of employees currently furloughed in the UK alone and it is highly debatable how many of these will return to jobs.
However, all is not doom and gloom for charities with investment portfolios. Share prices have rallied strongly from the March lows, driven higher by the flood of liquidity being pumped into markets by the world’s central banks and there are companies still paying dividends, particularly from the more defensive sectors of the stock market.
Sectors such as utilities, pharmaceuticals and food retailing (with the exception of Sainsbury’s) have been relatively unaffected by the virus and in some cases have actually benefited from increased trade.
Companies such as GlaxoSmithKline, National Grid, United Utilities, Tesco and Wm Morrison Supermarkets have all continued paying dividends throughout and in many cases have actually increased their payments to shareholders. Investors could also look further afield and examine specialist sectors such as infrastructure or certain areas of the property market that have proved resilient to the economic problems.
Well above gilt yields
Even with the potential fall in dividend income of 40%, the UK stock market will still be yielding well in excess of UK gilts, where yields remain well below the prevailing rate of inflation. Investors are, however, facing a real dilemma if they want income: do they sell the stocks most badly affected by the virus that are not paying dividends any longer to reinvest the safer areas of the stock market that can still generate an income, or do they trust in a strong recovery that will enable many companies to return to paying dividends quickly?
This is almost an unanswerable question as the pace of economic recovery will be crucially dependent on the speed and extent of lockdown measures being eased, which in turn depends on the success of these measures in controlling the virus spread. Right now there is the fear of a second wave in many countries plus the difficult situation in the US. It almost goes without saying but a reimposition of the full lockdown in the UK would be catastrophic for many industries.
After the run in the markets coming up from the bottom it would seem sensible to take a more cautious approach. Those charity investors who need investment income should concentrate on well-financed businesses with resilient cash flows which are capable of paying dividends even in the current circumstances. A strong balance sheet with either net cash or a sensible level of borrowings will allow companies to continue to distribute dividends even when trading is difficult.
Less cyclical economic areas
Resilient businesses tend to be operating in the less cyclical areas of the economy, which are not prone to large swings in demand. A good place to start would be those companies which have continued to honour their dividend commitments through the crisis. Companies such as Tesco, GlaxoSmithKline, Vodafone, National Grid and most of the major life assurance companies have not followed the trend for suspending payments and in some cases have actually increased their dividends.
National Grid is a good example of a business able to carry on increasing its dividend in the future. Its profits and cash flows depend on an allowed return (by the regulator) from its asset base. The group’s asset base is forecast to show strong growth, both here and in the USA, due to the changes in electricity generation and distribution as we move to greener energy sources.
The places where we are able to generate wind and solar power tend to be different from the locations of old carbon-based power stations. These new energy sources have to be connected to the grid meaning investment opportunities for National Grid and growth in its asset base. By extension this also implies profit and cash flow growth, which would able to fund a rising dividend.
Strong balance sheets
All the companies named above operate in areas that have not been severely affected by the virus and their cash flows and profits have been little affected. All bar Vodafone have strong balance sheets and Vodafone is expected to significantly strengthen its balance sheet by disposing of its mobile tower assets in the coming months. As such, these investments have already passed a significant test after the upheavals of recent months.
Whilst some of these may not be the highest yielding shares in the market, stocks such as these providing reliable income should prove to be attractive investments over the longer term notwithstanding the uncertainties that world stock markets continue to face in the short term.
Charity investors should always take a long-term view when investing in equities – share prices are by nature volatile as the recent past has demonstrated. However, even though stock markets fell substantially in February and March they have since risen sharply, illustrating that shares can be profitable places to invest even when the news is bad.
World governments are doing “whatever it takes” to protect jobs and the economy. Whilst this will come with large long term costs it should ensure that damage is minimised in the short to medium term and we can return to normality in due course, provided the virus remains under control.