When we analyse the performance of high-yielding stocks, more often than not investors tend to lose more on the value of their holdings than they receive in dividends, which begs the question why own them in the first place? This is particularly relevant to companies in the FTSE 100 which are widely perceived by investors to be rock solid sources of income.

Classic examples of companies which have destroyed more of their investors’ capital than they paid out in dividends are oil producers
and banks.

Shareholders in BP (BP.) for example have seen the company’s market value fall by £50 billion, or more than half, over the last 10 years compared with total dividend payments of just over £45 billion, excluding this year’s payout, leaving them collectively poorer to the tune of £5 billion according to analysis by AJ Bell.

Shareholders in Barclays (BARC) have had an even worse time, seeing the firm’s market value shrink by £20 billion in the last decade while dividend payments have totalled £7.4 billion according to AJ Bell, resulting in a net loss of close to £13 billion.

Many popular income stocks on the FTSE 100 have disappointed with earnings in recent years which has led to weaker share prices. It also seems inevitable that many companies will have to rethink their dividend policies for 2021, if they haven’t already done so.

In the case of the major banks, which were barred from paying dividends by the Prudential Regulatory Authority, in order to ensure they have enough capital to continue to lend to companies during the pandemic, future dividend payments are likely to be much lower than in the past. HSBC (HSBA) has already warned shareholders to expect any future dividend to be ‘conservative’.

With a second wave of virus infections hitting Europe and the US and threatening to slow economic growth, central bankers are under pressure to keep interest rates at record lows and there is even talk of negative interest rates. This would not only reduce the yield on bonds and fixed-income securities, it would support the notion of lower yields on stocks.

WHAT DOES THIS ALL MEAN?

All these factors suggest it is time for investors to rethink a) their portfolio holdings and b) how they generate income from an investment portfolio.

Too many people are clinging on to the hope that some of the popular FTSE 100 stocks for income will get back to historical dividend payment levels. We’ll discuss six sectors later in the article and offer suggestions on whether you should stay or get out.

We also present the argument that anyone needing income should consider picking stocks that can deliver good capital growth and then selling down chunks of shares to generate an income, instead of simply chasing high yielding stocks.

Before we get to those issues, let’s consider the role of the dividend.

IN DEFENCE OF DIVIDENDS

Ian Mortimer and Matthew Page, managers of the Guinness Asset Management Global Equity Income Fund (BVYPNY2), published a recent report arguing that dividends do matter.

Looking at the benefits of investing in dividend-paying companies and the comfort dividends provide in periods of market distress, they claim dividends deliver a ‘gradual but potent contribution to long-term returns’ as well as helping counter the effects of market falls and inflation.

They argue that dividends are proof of a company’s progress in as much as they are ‘hard cash’. Profits, as the saying goes, are a matter of opinion, while dividends are paid in actual pounds and pence.

Dividends ‘instil efficient capital management in mature businesses’, leaving ‘no room for vanity projects or frivolous uses of capital’ they claim. Dividend-paying companies begin each year by deciding the payout and then think about how best to use the rest of the free cash flow generated by the business.

According to the managers, dividend payments serve to identify companies that are disciplined and efficient in their capital allocation and cash flow management.

They use the annual returns of different categories of S&P 500 companies, from ‘dividend growers and initiators’ through to ‘dividend cutters or eliminators’, over the period from 1972 to 2019 to argue that dividend payers outperform the market on a total return basis.

While early-stage companies need cash to establish themselves, and need to reinvest in their businesses to take advantage of growth opportunities, once they become mature it is ‘entirely sensible’ that they allocate cash ‘only to those projects where they can achieve high returns, and give the rest back to shareholders,’ according to the Guinness managers.

LONG-TERM RETURNS

There is no doubt that over the very long term dividends deliver a proportion of total return which grows considerably over the life of an investment. Over a 20-year holding period, the managers claim that dividends account for an average 57% of total returns.

Dividends also provide a long-term hedge against inflation, as payouts tend to rise faster than consumer prices.

In periods of low economic growth, the proportion of total returns provided by dividends becomes even more important. According to the managers, in the 1940s and the 1970s, dividends accounted for over 75% of total returns.

However, these total return numbers are based on dividends being reinvested and the power of compounding, which only works over the very long term.

Investors who are looking for dividends as a source of income – for example to pay their bills or allow them to enjoy a comfortable retirement – aren’t interested in reinvesting or compounding. They want the cash now.

CONTRASTING VIEWS

Fundsmith chief executive Terry Smith, in the opposite corner, believes investors should never buy stocks for income. In an interview with Fund Insiders Forum, he says: ‘Dividends aren’t at all important to us. You should invest in equities for the greatest total return you can get – that’s the growth of the share price plus any income, and if you need to spend some money sell some of your holdings, which I know isn’t rational to some people but I assure you is the correct way to do this.’

Smith believes the ideal company doesn’t pay a dividend. He remarks: ‘If a company can make a 30% return on capital why would you want it to pay a dividend? By and large you can’t make a 30% return on capital, so you want the company to retain the earnings and generate that return for you.’

Chuck Akre, founder of Akre Capital Management, also believes dividends don’t matter and that companies should reinvest their cash earnings. ‘With an outstanding re-investor at the helm even an ordinary business can become a remarkable compounding machine. In the long run, the rate at which the value of a business compounds will approximate its returns on reinvestment.’

If a business generates a return of 20% and reinvests all retained earnings without paying dividends, its capital and earnings will both grow at 20% per year and its market price should grow at the same rate as long as the opportunity to continue generating high returns continues. Moreover, investors effectively get a tax deferral on the gains because they are retained within the company, not paid out.

Akre argues that ‘dividends are the route to average returns’, while reinvestment is the route to above-average returns. ‘Markets recognise and put a high price on businesses with high returns on invested capital. The price a shareholder pays for a wonderful business is typically a substantial multiple of the actual capital invested in that business,’ he says.

‘Unfortunately for the dividend-centric investor, it is this ratio of market price to invested capital that dictates the returns available to shareholders on any earnings paid out as dividends.’

Which raises another question: if a company can’t find opportunities to reinvest its cash at above-market returns, and pays out large dividends instead, should you own the shares in the first place?

BUFFETT DOESN’T PAY DIVIDENDS

The world’s best-known investor, Warren Buffett, likes companies that pay dividends, yet his investment firm Berkshire Hathaway has only ever paid a dividend once, in 1967. Buffett joked he must have been in the bathroom when the decision was made.

Today Berkshire holds a record high of $142.8 billion in cash, cash equivalents and US Treasury bills in its insurance and other businesses, yet it still doesn’t pay shareholders a dividend.

The firm accepts that short-term interest rates on cash and Treasury bills will remain low and says ‘our earnings from such investments over the remainder of 2020 will be substantially lower than in 2019. Nevertheless, we believe that maintaining ample liquidity is paramount and we insist on safety over yield with respect to short-term investments.’

In his 2012 shareholder letter, Buffett devoted almost three pages to the topic of dividends and whether they make sense. His core argument, in contrast to Guinness’s Mortimer and Page, is that ‘a company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors’ before considering any other uses for its capital.’

Berkshire’s own priority with available funds ‘will always be to examine whether they can be intelligently deployed in our                        various businesses’.

Next, it searches for acquisitions. Buffett admits his acquisitions haven’t always added value, but ‘overall, our record is satisfactory, which means that our shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.’

Finally, Berkshire uses funds to repurchase shares when they are trading at ‘a meaningful discount to conservatively calculated intrinsic value’. In the second quarter of 2020 the firm used $6.7 billion of cash to purchase its own shares. Buffett calls disciplined repurchases ‘the surest way to use funds intelligently: it’s hard to go wrong when you’re buying dollar bills for 80¢ or less.’

BUFFETT STILL SMILING

Instead of taking dividends out of the firm, Buffett has steadily reduced his personal holding in Berkshire over time, cashing in on the increase in book value, its greater earnings power and the market-price premium on the shares.

Despite selling down his holding, its current book value ‘considerably exceeds’ the value of his original stake. ‘In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased.’

Maybe it’s time that investors who think dividends are the only form of income took a leaf out of Buffett’s book. Invest in good companies, allow them to reinvest their income to create more value for shareholders, let their book value and market value rise over time, and take money out in an opportunistic way.

ANOTHER WAY?

If you don’t like that idea, you’ll need to be pickier with the stocks you buy for income. One way is to split the universe into three camps.

The first is to look for companies that throw off a lot of cash and generate high returns on capital, but don’t need all the cash for growth so there could be a good chance the excess is paid
to investors.

The second is to lump together companies that generate cash but have limited growth opportunities. They may have higher dividend yields but probably won’t keep pace with inflation.

The third group is where returns on capital are falling and the ratio of free cash flow to dividends is tight. This can be categorised as an            income trap.

Let’s now dive into six of the sectors most popular with income investors backing FTSE 100 companies.

 

BANKING

Banks? No thanks. Banks have historically been fertile ground for income seekers, but it seems likely that 2019 was the high-water mark for dividends.

The sector was already struggling to turn a profit before the pandemic due to weak loan demand, historically low interest rates and narrowing net interest margins. Add to that a spike in provisions for bad loans, due to the sudden contraction in the economy – UK GDP shrank by 20% in the second quarter, more than any other European country – and the potential for dividends and buybacks became even slimmer.

The Prudential Regulatory Authority, keen to ensure the banks kept lending to support the economy, told them to suspend dividends and buybacks until the end of this year. While the door is open to a resumption of payouts next year, HSBC (HSBA) has already warned shareholders that dividends are likely to be much lower than they have been used to.

 

TOBACCO

Time to make some hard decisions about tobacco stocks in your portfolio. The sector was once considered a dependable source of income, with cigarette manufacturers prized for their strong brands, pricing power and high margins, but the sector’s defensive attractions have lessened due to declining incidences of smoking and increasing political and regulatory concerns, including over vaping.

Both British American Tobacco (BATS) and Imperial Brands (IMB) have invested heavily in less harmful next generation products (NGP), though it will be a while before this investment pays off and there is a risk NGPs could cannibalise the profitable combustible tobacco business.

 

INSURANCE

Insurers are a better bet. While insurance companies were urged by the Prudential Regulatory Authority to ‘pay close attention to the need to maintain safety and soundness’ of their balance sheets, leading to the cancellation of most final dividends for 2019, the industry is well capitalised and payouts are likely to resume at much the same levels as before the pandemic.

Insurance is also less cyclical than banking, with most of us renewing our annual house or motor policy without question, even if that means shopping around using price comparison websites.

Among the major players, Aviva (AV.) is bolstering its capital with the £1.6 billion sale of a majority stake in its Singaporean life business, and last week declared a dividend on its cumulative preference shares.

Legal & General (LGEN), which bucked the trend by paying both a final 2019 dividend and an interim 2020 dividend, said at the half-year stage it would set a final dividend which was ‘prudent’.

The sector also looks cheap, hence last week’s takeover bid for RSA (RSA) at close to a 50% premium. We would buy both Aviva and Legal & General for income, with the stocks trading on 8.4% and 8% prospective yields respectively, according to SharePad.

Robust cash generation should help support the recently reduced dividend at Imperial, but an elevated forward dividend yield of 11.4% indicates the market isn’t convinced the new level of payout is sustainable.

Geographically diverse British American Tobacco is sticking to its target of a 65% dividend payout ratio, drawing confidence from large cash flows, yet a forecast yield of 8.4% also implies investors believe the dividend could be cut.

Liberum calls British American Tobacco ‘an elite group of resilient businesses who have been able to grow sales, earnings and cash flow during the challenging Covid-19 period.’ However, the company’s shares have halved in value in the past three years and return on equity has also dropped dramatically in this period versus pre-2017, making this a classic example of a high yielding stock losing shareholders money.

Value investors might think it is looking cheap and oversold, and nearly all the analysts covering the stock have a ‘buy’ rating. However, our patience is wearing thin with the business and its share price, so we’re inclined to say you’re better off looking elsewhere for income opportunities.

 

OIL & GAS

In the ranking of disappointments for UK income investors through the pandemic Royal Dutch Shell’s (RDSB) decision to cut its dividend by two thirds must sit at the top.

The company hadn’t cut its payout since the Second World War, yet Covid-19 provided cover for a decision which it may have wanted to make for some time, hence a big reduction earlier this year.

A subsequent 4% increase in the dividend will have done little to ease the pain.

A 2021 yield of 4.5% based on this rebased dividend, and 9% at its peer BP which cut its own payout in half, may look optically attractive but comes with a big risk warning attached.

Both companies face some serious challenges associated with depressed oil demand and volatile oil prices along with pressure from governments, regulators and investors to transition away from fossil fuels.

The investment required to move in a greener direction will put pressure on cash flow, already squeezed by a depressed oil market, and dividend paying capacity. BP may have to go further with cutting dividends.

We are switching from a positive to negative stance on Shell in recognition that the transition to renewables is going to take a long time and the oil price has remained much weaker than we expected earlier this year. We’ve been negative on BP for a while and that stance hasn’t changed.

 

UTILITIES

Utilities are a natural hunting ground for investors seeking out yield because they are perceived to have steady income streams, backed by providing essential gas, electric and water services that everyone needs.

Despite this reliability utilities have been impacted by the pandemic with many businesses using less energy and water and this hasn’t been fully offset by the increase in household use from more people working from home. As such, utilities are perhaps not the complete safe haven that some investors might expect.

One standout company in the sector which puts great importance on the payment of the dividend is energy group SSE (SSE), currently trading on a prospective dividend yield of 6%. The group has a policy of maintaining the growth of the dividend in line with inflation, which it reiterated at the annual results in June.

In addition, the company has been refocusing on its core businesses of regulated electricity networks and renewable energy while reducing net debts and improving its balance sheet, which provides more assurance for income seekers. A good stock to own.

 

PROPERTY

The big diversified real estate investment trusts (REITs) like Land Securities (LAND) and British Land (BLND) have run into trouble thanks to their substantial holdings in the structurally challenged retail space as well as an office market disrupted by Covid-19.

More recent FTSE 100 entrant, Segro (SGRO) is now valued by the market at more than these two combined.

Segro’s investment in warehouses chimes with the online shopping trend which has accelerated in the pandemic. Its yield of 2.4% is smaller than its peers but has more scope to grow with the current situation, and the outlook for rent collection and occupancy is robust.

On this basis the shares look a decent option for income investors prepared to accept a lower initial yield in exchange for the potential for dividend growth.

Elsewhere, the housebuilders are beginning to return to the dividend list, having been a source generous of yields pre-Covid. The outlook is uncertain given the economic backdrop but a difference from the financial crisis is that most constituents of the sector have very strong balance sheets this time round.

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