Financial markets are in turmoil and investing conditions are as challenging as this veteran investor of nearly 30 years’ experience can ever remember. With a fall of 23.2%, the Dow Jones Industrial Average has just posted its worst ever first calendar quarter performance in its 124-year history – despite reaching new all-time highs midway through the quarter.
In this note Mark Peden, the co-manager of the Kames Global Equity Income Fund, explains how he is managing this period of market stress and explains why his own portfolio is relatively well-positioned.
As the coronavirus outbreak became ever more serious outside of China, global stock markets proceeded to tumble by over 30% in their quickest time ever – a mere 22 days. Faster even than at any time during the Great Depression of the 1930s.
While investors are seeing capital values plummet, they are also facing a torrent of dividend reductions, postponements and outright cancellations that challenge the flow of income many rely on from owning shares. With the now unprecedented shutdown of global economic activity caused by countermeasures introduced to slow the viral transmission, there is a widespread corporate ‘dash-for-cash’ to ensure that businesses have enough near term liquidity to survive this severe demand shock.
Share buybacks are almost universally being withdrawn and company boards are accepting their social responsibility at this time to ensure that shareholders are not being unduly compensated at the expense of either rescue public (taxpayer) funds or employees being underemployed. Hence there will be a significant pressure to act on dividend payments.
Let’s look at two sectors which collectively account for almost one-quarter of the market’s dividend base.
Bank dividends in both the Eurozone and the UK are for the time being effectively government-controlled, with both the European Central Bank and the Prudential Regulatory Authority “recommending” that no shareholder distributions be made until 1 October 2020 and January 2021 respectively. This is not because the banking sector has a capital problem, instead it is entirely because of the ‘unique’ social role banks play in extending credit to the wider economy. Regulators want such saved capital to be used in channelling lending to those that are so in need of liquidity right now. That does immediately wipe out around 15% of the whole European dividend base
Energy companies are battling with a collapsed oil price and most cannot cover their dividends at this lowly US$20 per barrel level. That’s another 9% of the dividend base that is in danger.
It is also the case too that in many jurisdictions dividends need to be approved by shareholder Annual General Meetings before payment is allowed. Many of these are being postponed until later dates, given the current ban on large public gatherings. Some proactive corporates are still proceeding virtually, however.
Let’s put some harder numbers to some highly plausible future outcomes. In typical past recessions dividends are normally cut by around 10%, far less than earnings. Hence income-based strategies tend to be seen as more defensive in nature at times of stress. This, however, will not be a typical recession.
During the Global Financial Crisis we saw pay-out reductions in the region of 30% and over half of European companies cut their dividend. This, sadly, will be more representative of what is to come this time. For example. Recent estimates from Goldman Sachs suggest that S&P 500 dividends could be cut by 25% this year and Citi propose that European dividends could mirror the 50% drop in earnings this year that they now forecast.
Our time-tested investment approach is serving us well
So with that bad news out of the way, please remember that despite the depth and length of this huge economic shock, demand will resume, economies will recover and shareholder distributions will ultimately return to normality.
Skilled global equity income managers are now being presented with very real opportunities to avoid the worst of the pitfalls and minimise shortfalls in income (and there will be near-term shortfalls for all, please be in no doubt).
At Kames Capital, we designed our process to capture well-covered dividends paid by highly cash-generative companies with strong balance sheets. That’s what our proprietary dividend screening tool helps us to identify and looking at the current portfolio that’s what we own.
To illustrate, as at 31 March 2020 the representative portfolio for our Global Equity Income Strategy has:
A dividend cover ratio of 1.7x – This means the profits of the stocks in our portfolio are 70% above what they pay out in dividends. Or, in other words, their profits would need to collapse by more than 40% before our dividends would be just covered.
A ‘leverage’ ratio of only 1.3x – This measures how long it would take for the operating cash flow to pay off all debts. Anything above 2.5x starts to get a little uncomfortable, while most bank debt covenants are set at well over 3.5x.
A trailing return-on-equity of 19.5% – That is significantly above the market average and more than twice any current cost of equity estimate.
In short, we are invested in highly profitable companies that carry low debt levels on their balance sheets and generate very strong cash-flows that facilitate the payment of sustainable and growing dividends through time.
That is our investment philosophy in a nutshell, and thankfully it has directed us away from the exceptionally challenged banking and energy sectors, where, at only 8% of the portfolio, we are weighted much less than the market. In fact, here we only own four companies that possess the strongest franchises and financial profiles in their respective industries.
We expect, therefore, that our income drawdown will be much less than the market and we hope to experience as few dividend cuts as possible in the forthcoming period. At the time of writing we have faced only three payment suspensions out of a portfolio of 44 stocks. We will face more, but it should be a manageable number.
Given the unprecedented nature of this crisis we will not necessarily punish companies by selling out, for protecting liquidity rights now, as in many cases it will completely be the right thing to do.
Our approach has served us extremely well throughout the past 10 years and the wild, crazy quarter that just ended was no different. We continue to perform exceptionally well relative to peers in total-return terms, as well as delivering a one-year rolling premium income stream around 30% higher than the overall global equity market.
I hope this is useful for investors. If you have any questions please contact me through your usual Kames Capital representative.
Please stay healthy and safe.
Opinions and views from the Equities team at Kames Capital are not an investment recommendation, research or advice and should not be considered as such. Content discussing investment strategies and stocks is derived from and solely relates to the investment management activities of Kames Capital.
About the author
Mark Peden is the architect of our global equity income strategy and has been the lead manager of the Kames Global Equity Income Strategy since its inception in 2011. European equities are his main area of research expertise where he has been analysing companies since joining the firm in 1992. Over his tenure Mark has held a number of positions and managed a range of both International and European equity funds. He graduated from the University of York and the University of California (Santa Barbara) with a BSc honours degree in Economics with Politics. He a CFA charterholder and is also an Associate member of the UK Society of Investment Professionals (ASIP). He has 27 years’ industry experience.* *As at 30 November 2019.