News that UK banks will now freeze shareholder returns - following a Bank of England warning - will pile further misery on investors relying on income from dividends to fund their retirement. With yields on cash and government bonds at record lows, the case for equity income should, based on historic yields, be more compelling than ever. However, the equity investor is the fall guy in any crisis: the owners of the business are the last in the queue to be paid; and even if there are surplus profits, then authorities may now prohibit their distribution. Caveat emptor. Let the buyer beware!
This development will only serve to highlight the concentration risk of dividends in the UK stock market. The only sector contributing more than banks to the market yield is in fact Big Oil. This may not currently offer much comfort. With the price of oil now at a 20-year low, these behemoths of the FTSE will likely be loss-making this year. If they maintain their dividends – which have not been cut in 30 years - it will be through funding from increased debt. Subtract the dividends of the Banks and the Energy stocks (which together make up 37% of the UK market yield) and the UK market yields a more modest 4% rather than the more alluring headline historic yield of 6%.
We have previously pointed out that Europe (including the UK and even Russia) stands out globally as the place to look for equity income opportunities. The situation in the rest of the continent, however, is not radically different to the UK: banks have been told by the ECB not to return capital to shareholders and on a daily basis numerous other companies are citing the virus as a reason for shareholders to forgo their dividend. The market in dividend futures is current pricing aggregate dividend cuts across Europe of 60% (which would be much worse than the one third cut seen during the Great Financial Crisis). We have previously used the analogy of US fugitive William Sutton, who was once asked why he robbed banks: “Because that’s where the money is” as why we look to Europe for dividend income. There is a danger for equity income investors, not prepared to look beyond the usual dividend paying industries, that the robber successfully executes his heist, only to find that the bank manager may have in fact already have emptied the bank vaults of cash.
It is important that equity income investing does not simply fall into the value trap of relying on falling share prices and last year’s pay-out. We remain confident that the Argonaut Dividend Opportunities Fund can return an exceedingly generous yield. Moreover, we are investing in expectation, rather than just hope. The current portfolio contains no banks or energy producers; nor does it have exposure to those companies that might become tarnished by seeking state aid. The current crisis has highlighted the imperative for dividend diversification, which means more choice from a broader investment universe.
So where are we currently looking for dividend yield? Let’s start with Belgian shipping company Euronav. The collapse in demand for oil as well as the price war between Saudi Arabia and Russia has created new opportunities as well as threats. There is currently an exceedingly steep contango in the oil market (that is to say, the price for future delivery of a barrel of oil is much more expensive than delivery today). This means that oil traders are desperately trying to find storage capacity for current production, in order to make a theoretically risk-free future profit, when demand recovers. With traditional onshore storage reportedly nearly full, oil tankers are now being used, not for transportation, but to idly store crude. This takes significant supply out of the global fleet and underpins high day rates for ships for the foreseeable future. Consequently, Euronav’s shareholders, by virtue of this booming market and its strong balance sheet, will be paid out windfall profits.
Strangely, there is also the possibility that the virus together with the unprecedented fiscal and monetary policy eventually stokes an inflationary boom. Currently the mining industry is being impacted by labour shutdowns, particularly in South Africa, where most of the world’s precious metals are found. We have long been invested in Russian blue-chip miner, Norilsk Nickel, which along with much of the Russian market combines a modest valuation with a very generous dividend policy. We are attracted by the company’s position as the lowest cost producer globally in palladium and nickel. Currently palladium is supply constrained, inventories are low, and this situation may be further exacerbated by the current crisis.
Finally, although we think it is currently too early, we believe that the crisis will ultimately result in the providers of new capital attaining higher returns on invested capital than legacy shareholders. Take reinsurance – the traditional industry safety value – with Swiss Re the market leader. The industry as whole will take a massive loss from the stay-at-home economic mayhem. It will need to pay-out on many insured events previously priced as unlikely. This will result in a reluctance to do business at legacy prices and supernormal returns for shareholders prepared to underwrite new business at higher prices that adequately compensate for future risk. We will invest with an eye to these opportunities to buy into stocks after balance sheets are fixed at cyclical lows.
Like a child with a safety blanket, after markets have fallen and dividends disappoint, it is understandable for fund managers to highlight only the most secure and obvious plays; these may not be the best opportunities at current market levels. Although the current crisis will inevitably have long term structural economic effects, its effects on the stock market are in my opinion likely to be brutal but relatively short-lived. Whilst mainstream dividend streams are now in peril, we believe that this is an opportunity for skilled active fund managers prepared to go beyond the usual suspects to differentiate both in terms of income and overall return.
Barry Norris
Argonaut Capital
April 2020
