Thinking globally for sustainable income
The challenges of running a charity have been amplified by the current pandemic crisis. The need to spend money is greater than ever, the provision of services has become harder and at the same time many sources of income - from donations to rent from property to other commercial revenues - are under pressure.
Income from investments has become doubly important to charities which have them. But in many cases those investments have also been found wanting. It is expected that income from the UK equity market will fall by over 40% in 2020, and it is often the highest yielders which turn out to be the most vulnerable in times of crisis. Such businesses have tended to be well-represented in charities’ portfolios.
Some charities’ investments are managed on a total return basis, but even they will have to consider how much capital they can sustainably spend in the face of considerable uncertainty. The challenge of “inter-generational equity” or, put another way, the risk of supporting today’s beneficiaries at the expense of tomorrow’s, has been heightened for everyone.
Equities are essential
It is widely accepted that equities should represent the bulk of a charity’s investments. When charities own shares, they own slices of real, cash generating businesses, and if they own shares in companies which can grow their cashflows over time then the dividends they receive will also grow, and this in turn will lead to capital growth as well. This ability to deliver both income and growth is what makes equities such a good fit for income-seeking charities with a long term timeframe.
The investment industry however has tended to overcomplicate matters, interposing complicated benchmarks, agonising over targets and layering costs. But investing in dependable, growing businesses from around the world to provide dependable income, and also growth in income and capital over time, has more than held its own in recent months and years.
Not plugging the income gap
When times are tough there is a temptation to trade into high yielding stocks to “plug the income gap”. Wherever a company has withdrawn its dividend and there is a hole in the charity’s income stream, there will be an impulse to sell that company and reinvest the capital into another high-yielder, whether that be an oil company, a retailer, a tobacco company or a REIT, most of which now trade on high dividend yields.
This strategy is doomed to fail. Many of these seemingly high yield dividends will prove to be a mirage. In the current environment there is unprecedented uncertainty about which companies will pay their dividends and which will not. Selling a dividend cutter to buy a company which subsequently reduces its dividend will simply incur trading costs.
There is also a high risk that trying to plug the income gap will end up destroying capital value. Earnings and dividends ultimately determine capital value, and many high-yielding companies suffering large drops in earnings and dividends will simply not see a bounce-back to the levels they enjoyed before the coronavirus struck. Such companies face a permanent impairment of their dividend paying ability.
Avoid struggling sectors
It is important for dividend investors to remember that before Covid-19, high street shops and retail REITs were already under intense pressure from ecommerce. Oil companies were already fighting a losing battle against the long term decline in hydrocarbon consumption. Banks were riding an unusually long wave of near-zero loan losses.
Carmakers and airlines, viciously competitive industries for decades, were in most cases making no economic profit. In other sectors, many companies were simply over-distributing capital, whether in buybacks or excessively high dividends.
Once the world defeats Covid-19, these companies are highly unlikely to see their earnings and dividends resume at pre-crisis levels. Established trends are simply being accelerated by the current crisis. There will be no “reversion to the mean”. Many companies are facing a dividend reset, not a V-shaped bounce.
Purchasing these troubled companies in the hope they will pay high dividends that plug the gap is therefore a doubly dangerous game. Not only is the dividend uncertain in the near term, but as investors digest the reality of these companies’ permanently impaired earning power and dividend paying ability, their capital value post-crisis is unlikely to rebound. This is true risk – the permanent impairment of capital value.
What about the less cyclical high-yielding sectors that charities seeking income have traditionally turned to, such as utilities, tobacco, and telecoms companies? Unfortunately these are mature sectors, fraught with regulatory risk, and with weak long term growth prospects.
They may offer some near term security of income. But the charity which piles into these sectors to plug a short term income hole will face the near certainty of very dull long-term profit growth. It is not a coincidence that many companies in these “low risk” sectors, from Vodafone to Centrica, have failed to deliver profit growth over long periods – and in many cases have had to rebase their dividends.
Shares of the future
The beauty of equity markets is that charities can avoid the companies and business models of yesterday and invest instead in the shares of the future. This may limit immediate dividend income, as these companies have a lower yield than others which are ex-growth. But in the long term these companies are likely to pay off in far higher levels of income, together with strong capital appreciation.
For every company facing a prolonged period of troubled times, there is another for which Covid-19 will ultimately prove transitory. Great companies with relevant business models will undoubtedly see earnings and dividends bounce back.
Well-run insurance companies, for instance, will continue to play a vital role in protecting policyholders against disasters – and the value of that insurance may well be higher in a post-pandemic world. Innovative manufacturing companies, with products that genuinely enhance the efficiency of their customers, will see their earnings bounce back too.
Delivery companies will find their services in ever-greater demand. Restaurants which are happy to deliver as well as host diners will surely thrive. Even in the property sector well-invested residential assets, in a post-virus world of Zooming and flexible home-working, will generate solid rental income.
Yet a UK-only approach to dividend income is extremely narrow. There are roughly 250 dividend paying companies in the UK, not a huge number for active stock pickers, and the market is dominated by companies in structurally challenged industries. Many have been paying out too much in dividends rather than reinvesting for the future.
Worldwide, there are about 4,500 dividend paying shares to choose from. Many of these are great companies with strong business models that will remain relevant for years to come. Going global provides charities with the chance to escape from the risks of UK oil companies, banks, high street retailers and other troubled companies which make up so much of the UK dividend sector.
Instead charities become free to choose the well-run insurers, the value-add manufacturers, the delivery companies and so on which will thrive in the future. Such portfolios will be far more likely to bounce back from this crisis.
Responsible and sustainable income
Trustees today are accountable to all their stakeholders and so rightly pay a lot of attention to whether their funds are invested responsibly. For some time excluding harmful areas such as tobacco from which charities do not wish to profit has been part of this, but charities today are also trying to consider whether their investments are influencing climate change.
With tobacco firms and fossil fuel companies having been notably poor investments over recent years, as well as a source of many dividend cuts, it is hard to argue that charities avoiding these areas have “missed out”, as they were once warned that they would.
It is important to invest sustainably, because over the long term it is growth which delivers a rising income, and sustainable growth is more likely to be delivered by companies which think holistically about risks such as climate change, about the welfare of their staff and about the safety of their products.
There’s also a role for asset managers to play, in encouraging companies to put long term considerations ahead of pleasing “the market”. This engagement is an essential element of investing responsibly, and has rarely been as relevant as today, when there are so many pressures on companies to take the short term view.
The challenges facing charities are manifest but, in the field of investment at least there are solutions available. Charities must invest responsibly, in resilient companies which are well-placed to deliver both for beneficiaries today, and those who will follow them in many years’ time. Such investments, selecting companies from around the world, can deliver sustainable, even rising income, and are well placed to meet charities’ needs, even in today’s uncertain world.
