In recent weeks we have debated at length the impact that the ongoing coronavirus crisis is having on the global economy and financial markets. One of its more noteworthy effects has been the contrast between businesses that are relatively well sheltered or perhaps stand to benefit from the long-term impact of the outbreak and those with weaker financial positions or whose business models are most at risk in the current environment.
Some sectors, such as Airlines, Leisure & Hospitality, and Energy, have understandably experienced broad-based weakness, as world-wide travel has ground to a halt; restaurants, pubs and bars have been forced to close; and demand for oil has fallen abruptly. Others, such as Utilities and Consumer Staples, which have historically been more defensive, and Technology, which is broadly less impacted than others, have fared better.
It is perhaps more revealing and more interesting, however, to look at the differing impact on companies that operate within the same sector, or at least compete with one another for customers.
For example, reports over the last week have advised that US department store chain J.C. Penney are close to filing for bankruptcy. Macy’s, often seen as a bellwether for the US department store space, is expected to see sales declines of around 20% for the full year, with revenues expected to be down over 30% in each of the next two quarters. Contrast this with Amazon, which has no “bricks and mortar” and no grocery retail exposure, which estimates first quarter North American online sales growth of over 30%. Its shares are up over 30% year-to-date.
In some cases, the shutdown-related closures and collapse in demand, whilst giving an unparalleled challenge in the short term, may only have hastened the demise of “old economy” companies that were already in structural decline. In the case of Macy’s, the company was already experiencing falling same store sales (a key metric in retailing) as customers migrated online or to specialty retailers.
Elsewhere, in sportswear, Under Armour have battled against a loss of brand momentum due in part to an over-reliance on discounting and off-price to drive sales. Nike shares, meanwhile, have beaten estimates in its latest results. Nike is the most innovative company in the space and its scale allows for greater relative investment in its brand. This includes a very well-developed digital strategy which paid off in the first quarter of the year, as engagement with its network of training applications translated into strong online sales in China both during and after the period of lockdown in the country.
While Utilities have been one of the better performing sectors this year, there too has been significant deviation of those working in this space. Companies with higher exposure to renewable generation have broadly outperformed, as these activities are often supported by subsidies and therefore less exposed to recent declines in power prices than thermal generation activities. Additionally, future fiscal spending to support economies might be targeted at decarbonising the global economy, which would support the long-term growth in renewables at the expense of more carbon-intensive methods of power generation.
In supermarkets, another sector that has been relatively strong performer, there has been better performance from those businesses that are best able to provide delivery services. For example, Sainsbury’s share price is trailing well behind those of Ocado, the world’s largest pureplay online grocery business, whose shares are up over 20% since the beginning of the year.
These somewhat subjective examples of divergent performance are supported by data which show that the dispersion of stock returns is at its highest level since the financial crisis of 2008/9. Furthermore, the breadth of the equity market recovery since the March 2020 lows has been very narrow. As measured by the percentage weight of the largest five stocks, the S&P 500 is now more concentrated than it was before the tech bubble in 2000, with Alphabet, Amazon, Apple, Facebook and Microsoft accounting for c.20% of the market capitalisation of the entire index of 500 stocks!
This uneven performance is expected to continue over time as the coronavirus outbreak has a lasting impact on society and the global economy. New themes will emerge from the crisis whilst existing ones will be expediated, and the businesses that are best positioned to benefit from these themes will stand to prosper. The crisis will also structurally and permanently impair the demand for certain products and services, with some businesses unlikely to ever fully recover.
The COVID-19 pandemic is likely to create long-term winners and losers in the stock market, and the absence of a direct historical precedent means that following the playbooks of previous market downturns may provide no clues for investors. For example, a “passive” approach of allocating capital across a broad equity index may be a less successful strategy than in previous crises, given that these indices almost certainly contain equities from companies in structurally impaired sectors, or exposure to businesses that are at a competitive disadvantage to their peers, as highlighted above. Against this backdrop, we expect there to be an opportunity for well-managed, active investment strategies to outperform the market.
The theme of dividends has long been the subject of important debate amongst the financial community. Academic research has been devoted to attempting to judge the importance of dividends in the valuation of a company. Some have suggested those that pay dividends are more valuable than those that do not, all else being equal. Others have suggested the opposite.
Dividends are often an important factor in the distinction between investment styles, specifically growth investing and value investing, with the latter far more likely to invest in companies with high dividend yields, while the former is likely to have a preference for those companies that reinvest earnings back into their businesses for growth purposes.
Against the backdrop of the ongoing coronavirus outbreak, and its impact on the global economy and the value of financial assets, dividends are once again back in the spotlight. More than 150 companies in the UK have cut, cancelled or suspended their dividends since the start of the Covid-19 crisis, with companies abroad also putting dividends on hold. For some of these companies, this course of action has been necessary in order to safeguard the future of their businesses. For others, the dividend terminations have followed government or regulatory pressure, with the UK banking sector being a notable example.
The relevance of a dividend is related to a variety of factors, but primarily it should be a function of a company’s stage in the corporate life cycle. For mature businesses, with lower reinvestment opportunities, a high dividend pay-out ratio – that is the percentage of net income a company pays out as dividends – may well be appropriate.
However, only investing in companies that pay high dividends means that you are likely to be overexposed to certain types of businesses at the expense of large parts of the investment universe, including geographies in which dividend payments have customarily been lower such as the US. For example, an investor attracted only to income would likely never have owned shares in companies such as Amazon, Nike, and Google – just three of many more companies that pay no or relatively low dividends but have produced strong total shareholder returns over long periods of time.
That said, dividends can help to support shareholder returns and also act as a useful check and balance for management, helping to avoid errors in capital allocation such as ill-judged mergers and acquisitions or expansions into new areas in which the company has little expertise or competitive advantage. Any investor should consider the track record of a company’s capital allocation decisions when considering the relevance of its dividend.
Overall, our Fund Managers believe that the appropriateness of a company’s dividend policy should be considered very much on a case by case basis, with reference to where that company is in its business life-cycle, its reinvestment opportunities and its track record in capital allocation. They would also stress that it is total shareholder returns that is the most important performance metric for investors, not the amount of income received and that focusing purely on yield excludes investment in certain high quality businesses which they would argue have more value accretive opportunities in which to put their cash to work than merely returning it to shareholders.
Also, in these unprecedented times, investors must look beyond a headline yield and study the financial strength of the business, the likely impact on its profitability and cash flows from the ongoing coronavirus outbreak, and the possible influence of government and / or regulators in assessing the safety of a company’s dividend.
We hope everyone and all our clients remain safe and well during this time as we begin to see the green shoots of the recovery that all had hoped for.
Clarion Investment Committee
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