Active Equities Point of View

Dividends in danger?

July 01, 2020 / Q&A with Tony DeSpirito

 

Pandemic-related stresses have prompted talk of companies having to reduce or eliminate their dividend payments to preserve operating capital. Tony DeSpirito suggests estimates of dividend cuts may be overstated and explains why equity income is even more important for investors today.

  • With interest rates at historic lows, investors need income from equities.
  • Analyst estimates of dividend cuts rarely bear out, even in recessions.
  • We see underlying company quality as a key marker of dividend resilience ― and active management as key to identifying it.

Why do investors need dividends today?

As populations are aging, the need for income is growing. Yet interest rates, and government bond yields, are at historic lows ― even negative in most parts of the developed world. Rates are likely to stay at the current lower bounds as central banks do their part to prop up economies in the wake of the coronavirus crisis. The Fed recently signaled its intent to keep U.S. rates near zero through 2022. All of this means the traditional income engines are falling short of investors’ needs.

Meanwhile, equity income is attractive in comparison. The yield spread on the S&P 500 Index and 10-year U.S. Treasury is the widest in stocks’ favor since 1955. At the end of May, the Treasury yield was below 1% while the S&P dividend yield sat near 2%. Not only are stocks yielding more, but equity income has the potential to grow over time while bonds (true to their “fixed income” label) pay fixed coupons until they mature. And companies with a record of dividend growth have demonstrated the best performance across time. (See chart below.)

Dividends pay
Returns of the 500 largest U.S. stocks by dividend policy, 1978-2019

Returns of the 500 largest U.S. stocks by dividend policy, 1978-2019

Source: BlackRock. Data from 12/31/78 through 12/31/19. The investment universe is the 500 largest U.S. stocks by market cap. Dividend policy constituents are calculated on a rolling 12-month basis and rebalanced monthly. Category returns are calculated on a monthly basis. Shown for illustrative purposes only. Dividend growers & initiators represent companies that either increased or initiated their dividend distribution. The Equal-weighted universe represents the 500 largest U.S. stocks by market cap, calculated by assigning the same weighting (0.20%) to each constituent. The No change category represents companies that pay a dividend but have not increased nor decreased their dividend distribution. Non-dividend payers represent companies that do not pay a dividend. Dividend cutters & eliminators represent companies that either cut or eliminated their dividend distribution. Figures shown reflect past performance. Past performance is not a reliable indicator of current or future results.

Will companies have to cut their dividends in 2020?

These are unusual times, and dividend cuts are inevitable. Companies are built to weather recessions, but not complete loss of revenue. They will have to take steps to recapitalize their business and ensure their own liquidity. At its trough, the futures market was pricing in a 35% cut in 2020 S&P 500 dividends. This would have the index’s yield drop from 2.4% to 1.6%. Ultimately, the pace of this recovery and, in turn, the true risk of dividend cuts will be driven by the virus. But our base case view is that dividend risk is overstated.

Through June 1, 48 companies in the S&P 500 and 99 in the Russell 1000 have cut their dividend this year. We look at operating quality and balance sheet strength as good indicators of the likelihood of dividend cuts. We also use a quantitative research screen to assess our investment universe for companies at risk of cutting their dividends, assigning rankings to each. If we’re doing our job well as active managers, identifying potential cutters is one way we can add value in this uncertain environment. Since 1980, our screen identified about 75% of dividend cutters as “high risk” in the months leading up to the cut. This is important because, historically, analyst estimates of dividend cuts have missed the mark.

In any given year, we find analyst estimates of a dividend cut for any individual company are overstated by nearly five times. The flip side is that the dividend reduction among the cutters is roughly double the prediction. The gist of it is that no company wants to reduce its dividend, as it sends a strong message to the market and reflects poorly on management. But once forced to cut, companies typically try to ensure the reduction is large enough so that they don’t have to cut again.

Where might we see the largest dividend cuts?

This crisis is unlike any before it. It’s hard to know how long it might last and how long companies can sustain their current dividend payments. Who could be at greater risk this time? Perhaps energy companies given the collapse in oil prices.

The critical exercise is to avoid companies leading into the cut. Many investors have a knee-jerk reaction to sell once the dividend is cut. But the pain is usually felt ahead of the action, as the market anticipates it. (See chart below.) In fact, selling after the dividend cut may be a mistake. In the global financial crisis, dividend cutters and eliminators outperformed over the following 12 months. Our proprietary quant model has been particularly effective at predicting which dividend cutters are likely to outperform.

The pain precedes the cut
Performance before and after dividend cuts, 2002-2019

Performance before and after dividend cuts, 2002-2019

Source: BlackRock, with data from Bloomberg and Refinitiv over the period 12/31/02-12/31/19. The investment universe is the Russell 1000 Index. The chart shows excess returns by dividend action in the months before and after t = 0, which represents the month-end after the dividend action took place. Shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

The key, no matter what the sector, is to be discerning. Our research has found that companies with poor operating quality make up the majority of dividend cutters in recessions. We focus on quality companies with a record of sustaining or growing their dividend across time.

What are the warning signs for a potential dividend cut?

If you look at cutters prior to the action, you’ll notice poor profitability, lack of competitive advantage, higher leverage, poor trends and cheaper valuations. They also tend to be amongst the highest yielders, the implication being that the dividend is not only high but unsustainably so. Our quant model screens for these characteristics.

We believe fundamental research is critical to both avoid dividend cutters and to inform the best course of action after a dividend action. It is notable that there are far fewer analyst estimates of company dividends than earnings (an average of three analysts on dividends versus 15 on earnings). This underscores for us the importance of active management of dividend strategies, especially in the type of uncertain environment in which we find ourselves today.

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Tony DeSpirito
Tony DeSpirito
BlackRock Fundamental Active Equity Investment Team
Antonio (Tony) DeSpirito, Managing Director, is Chief Investment Officer of U.S. Fundamental Active Equity. He is also lead portfolio manager of the ...