Income investing in the summer of the UK ‘super dividend’

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Just a year ago, the UK was mired in uncertainty marked by Covid-induced lockdowns, market outflows, deflation fears and an unprecedented dividend cull with scores of companies reducing, deferring or cancelling their income payouts altogether.

The Bank of England last March even directed banks to cancel their dividends, a step that would have been considered unthinkable before the 2008 financial crisis. Meanwhile, energy group Royal Dutch Shell cut its dividend for the first time since the second world war, in a body blow to the UK cult of equity income.

Today, uncertainty still prevails but the macroeconomic backdrop has flipped almost to the polar opposite, with economies reopening, market inflows, inflation fears and a summer of “super dividends”.

Investors love dividends with good reason: they’re the tangible return you get from equity ownership, the pound in your pocket versus the uncertainty of not knowing how an investment will perform. For income investors the next few weeks will be interesting and important in equal measure, as a very large percentage of the FTSE 100, from miners to oil companies and banking groups report results.

On Friday, NatWest said it would return an eye-catching £3bn to shareholders through dividends and share buybacks over the next three years. Banks look to be in a strong position to increase their dividends — albeit from a significantly lower base than in 2019 — capitalising on the twin benefits of a strengthening economy and the prospect of widening lending margins. House prices have continued to rise and the credit quality of bank customers is good, owing, in large part, to a considerable rise in household savings over the past year.

Mining companies, meanwhile, are benefiting from a strong demand for commodities including iron ore and copper, as trillions of dollars have been poured into recovery packages. Years of production and cost cuts throughout the sector mean the UK’s low-cost miners — Rio Tinto, BHP and, to a lesser extent, Anglo American — have been in a prime position to benefit from a rapid change of scene.

Last week, Shell raised its quarterly dividend by 38 per cent from the previous three-month period, to 24 cents per share. Like its peers, Shell benefited from a strong and sustained rise in oil prices, from a low point below US$30 in 2020 to more than US$70 in the second quarter of this year.

Results this week from HSBC — once the world’s largest dividend payer — were accompanied by news that the bank’s dividend had been restored, while better than expected earnings in the first quarter at BP — due to report on Tuesday — bode well for investors on the hunt for income from the oil major.

These hefty rises in dividend payouts are set to elevate the equity income available from the UK market. The bigger question, however, is how sustainable are they beyond this summer bonanza?

Carl Stick, manager of the Rathbone Income Fund, says it is important for investors to understand that some of these “super dividends” will not be maintained. He says income investors need to adopt a pragmatic approach. Don’t rely on super sector income returns to generate all income — instead think of these as “cream on the top” and focus on long-term income growth — those companies that are well positioned to offer investors a “pay rise” every year.

Take a close look at the fine print of dividend announcements. What are companies saying with regards to their payouts? Investment decisions by management are one indicator. If a company is making lots of cash profits, is that being ploughed back into the business through reinvestment? How successful is this likely to be? Too much cash returned to investors can undercut future profits. Is management striking the right balance?

It may be pragmatic for income investors to see this year as a one-off post-pandemic “bonus” and think instead about the dividend impact next year. Even before the crisis, there were concerns about the sustainability of dividends, as companies were more fearful of disappointing income-hungry shareholders than using up cash that could otherwise be spent on capital investment.

The FTSE 100 is expected to yield 3.7 per cent this year, supported by dividend cover of 1.5 (£1.50 of earnings for every £1 of dividend), figures which underline the need for investors to lift the lid on companies’ finances.

For income investors, the next few weeks are crucial. While the good news on dividends clearly has further to run, it is by now well understood that the UK’s big dividend payers face many structural issues. The oil majors have a delicate balancing act to perform if they are to transition to integrated energy companies, without weakening the prospects for their core fossil fuel assets, while mining companies face many challenges on environmental, social and governance (ESG) issues.

Still lagging behind its peers, the UK remains an unloved market. As the country grapples with the fallout of Brexit, the region’s main attraction in today’s low interest rate world is its high dividend culture.

With a momentous results season upon us, UK investors should remember how much personal wealth in the form of pension funds is held in companies including BP, Shell, Lloyds, Barclays, Rio and BHP. What companies do with the cash they generate in the good times is of fundamental concern. It explains why this results season is so important, accounts for the contrasts with last year and underpins why the bad news we got used to absorbing is key.

In the summer of the super dividend, the sustainability of dividend payouts matters more than ever.

Maike Currie is head of personal finance content at Fidelity International and author of “The Search for Income: An Investor’s Guide to Income-paying Investments”. The views expressed are personal. Email: [email protected]; Twitter: @MaikeCurrie; Instagram: maikecurrie