There are three lessons that UK income investors can learn from 2020’s “unusual” events, according to Royal London Asset Management’s Richard Marwood.
Last year was one of the most difficult on record for equity income investors, after the coronavirus crisis caused an unprecedented number of dividend cuts and cancellations across the globe, with the UK being hit especially hard.
Below, Marwood – a co-manager on the £1.7bn Royal London UK Equity Income and £975m Royal London UK Dividend Growth funds – highlights some of the lessons that 2020 should have taught investors.
Be wary of high yield companies
The first lesson is that a company with an extremely high yield can be attractive for income investors but it is also a warning sign.
“Just chasing after the very highest yields does come with a health warning and you have to be very certain that that is a sustainable yield and is long term backed by cash,” Marwood (pictured) said.
Holding only companies which have a significantly high yield can also lead to portfolio concentration problems, he added.
“If you'd taken the view in 2020 that you're only going to keep holding companies that were currently paying high yields, you would have ended up in a very narrow list of stocks,” the manager said.
“There's still a wide enough spread of companies paying interesting dividends in the UK markets, I don't think it's going to get any more difficult than it has been in the past. But concentration is always an issue.”
Look for sensible debt structures
A second lesson is investing in companies which have a sustainable debt structure, because this could impact the dividend payments.
The Royal London UK Equity Income fund, doesn’t hold companies which are “overly indebted”. Marwood clarified that it’s not a case that it won’t invest in companies with some debt, it just has to be “the right level of debt”.
Cash flow is the heart of what Marwood and co-manager Martin Cholwill are looking for when it comes to potential investments and is a key factor in their investment process.
He added: “The key thing that we're looking for is businesses that have got a decent cash flow because ultimately the cash flow makes it grow and you actually need cash to pay the dividend. If you’ve a business that isn't generating sufficient cash to pay the dividends and sustain and grow itself, then it's going to end badly at some point.”
Ultimately he said: “If [there’s] going to be trouble it’s always going to be the dividend which is used to sort the debt out.”
Stress testing
The final lesson was something which markets in 2020 provided in an extreme way: stress testing businesses and seeing if they can handle a worst case scenario.
Marwood said : “2020 was quite sobering, because normally if we look at a business and we think about stress testing, what’s going on in the business in a bad year, you might think about a company losing 10 or 20 per cent of its sales. And thinking what the impact is on the business based on that.
“Last year was extremely unusual, in that you have some businesses where their turnover almost disappeared entirely. I'm hoping that's not going to be something that we see again.
“But that was some that was something new and different and very much a learning experience.
“Some of the businesses that we look at, for example WHSmith, some of their business absolutely stopped dead last year, which is not something that we're used to but that's been an interesting learning experience, I think, from 2020.”
2020 was an undeniably tough year for the UK income space, which saw headline payouts from UK companies dropped 44 per cent in 2020 to £61.9bn – the lowest annual total since 2011, according to Link Group’s UK Dividend Monitor.
The UK was hit especially hard versus other income markets partly because the market focused on just a handful of names and sectors, such as banking and oil. These sectors saw some of the largest payout cuts and widespread dividend suspensions at the start of the crisis.
But while the early weeks of the Covid-19 storm were painful, the period was also a major buying opportunity, one which Marwood regrets not taking more advantage of.
“In our main income fund [Royal London UK Equity Income], we didn't really get the opportunity to buy anything else,” he said. “In some ways that was a little bit of a regret because there were some bargains out there this time last year.”
The manager explained that he and Cholwill made the call to hold back on investing capital because they didn’t know how investors were going to react to the crisis and if they were going to withdraw their cash.
“The problem is that as a fund manager, you're never always certain what your end clients are going to do,” he said.
In the early days of the Covid-19 crisis, vast amounts of cash withdrawn from funds as investors scrambled for liquidity.
This was especially seen in the UK focused funds, which were hit with consistent outflows for eight months totalling £2.2bn, according to the Calastone Fund Flows Index. This streak was only just broken in February 2021 when “investors tentatively dipped their toes back into UK waters”, Calastone said.
Marwood said: “Even if we think that the market is very, very cheap at a certain point, if everyone's panicking and our end investors want to exit the market, in a way were forced to sell to achieve that then it doesn't matter what we think because our end clients made that decision.
“We weren’t as aggressive about buying at the bottom because we weren't sure what the reaction was going to be of the clients.”
In the four FE fundinfo Crown-rated Royal London UK Dividend Growth fund, Marwood said he was “a little bit less concerned” about the same situation playing out so he was able to buy more as the market bottomed in March-April.
One company he added to the fund was Rentokil, a pest control company. It was sold-off heavily in the initial Covid trough but has recovered “very sharply” since then.
But the main thing Marwood said he focused on – especially in the Royal London UK Equity Income fund – was supporting companies which he felt would still have a strong business case after the Covid-19 crisis, but required more money to get through it.
He said: “Actually last year in some ways it wasn't always a question of what you're going to sell, it was actually which businesses you were going to support with more cash.
“There were lots and lots rights issues and placings last year because a lot of businesses just needed more cash to survive and get them out on the other side. In a way that was the more important thing, looking through the portfolio thinking, ‘right which of these businesses are long term viable and are worth saving?’ and prioritising cash in that area.”
Some examples of this were WHSmith and The Restaurant Group, both very consumer facing businesses.
“In the income fund it was more a case of buying things that we already held and in a few of the [other] portfolios it was a little bit wider,” he said.
Over the past five years Royal London UK Dividend Growth has outperformed both the IA UK All Companies sector and the FTSE All Share index, with a total return of 59.56 per cent.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
It has a historic yield of 2.62 per cent and has an ongoing charges figure (OCF) of 0.71 per cent.