If investors could have avoided the 2020 dividend …
“The world has changed seriously in the last few months,” said Ben van Beurden, CEO of Royal Dutch Shell (RDS.A), in an April 2020 statement announcing that the integrated oil and gas giant was cutting its dividend for the first time since World War II. “The global economic downturn and uncertain prospects have a significant impact on our profitability, cash flow and balance sheet, “said Van Beurden, forecasting that Shell would” build our resilience, maintain the strength of our balance sheet and support long-term value creation “by increasing the quarterly dividend by 66%.
Shell was hardly the only company whose dividend fell victim to a “seriously changed” world. The pandemic-induced economic slowdown caused thousands of companies around the world to reduce, suspend, or cancel shareholder payouts. For investors who rely on dividends for income, cuts were a disruption to cash flow. And because they reflected greater business challenges, dividend cuts have usually been accompanied by declines in prices. Shell lost around 40% of its market value in 2020.
The pandemic has been described as a black swan event. Blind companies cut their dividends so they could survive, fighting for another day, or even as a condition of government support. Should dividend investors simply calculate 2020 for unforeseen events and move on?
In fact, 2020 provides a valuable stress test for screens used in Morningstar dividend indices. Our research shows that high quality, financially healthy companies were most likely to be able to maintain their payouts in 2020 -run patterns.
The dividend disaster of 2020
Of the 7,365 constituents of the Morningstar Global Markets Index, which includes developed and emerging market stocks in large, medium and small capitalization segments, around 6,083 paid dividends as of January 2020. Of these, 2,434 companies cut their dividends in 2020, by far the highest percentage since 2008-09. In the US, cuts were far less common. Of the 981 payers, 91 have cut their dividends.
Sections are defined differently depending on the region. For the United States and Canada, where dividends are paid regularly, we calculated the reported dividend per share by annualizing the last dividend paid by the company. If the company cut its dividend per share year over year, that counts as a cut.
For stocks outside of North America, cuts are determined by comparing the adjacent fiscal year-end dividend per share numbers over a multi-year period. If the company cuts its dividend per share year-over-year, that counts as a cut. Outside of North America, cuts are far more common. In some markets, dividends are often paid opportunistically when the company has excess cash on hand.
The hardest hit were what are known as BEACH stocks – booking, entertainment, airlines, cruises and hotels. Companies such as the Intercontinental Hotels Group (IHG) in Great Britain, Universal Entertainment in Japan, Flight Center Travel Group in Australia, Singapore Airlines (SINGY) and Royal Caribbean (RCL) cut dividends as travel restrictions and social lockdowns brought their business to a standstill.
But many companies in all sectors of the economy have been forced to reduce, suspend, or cancel payments to shareholders. The chart below shows the dividend cuts by sector. Shell symbolized a bigger trend as the energy sector, suffering from falling demand and a price war between oil producers, was the largest cutter in the world. Among the cutters were companies such as ENI, Equinor, Marathon, Suncor, Woodside Petroleum, Gazprom and Petrobras.
Financial Services battled headwinds from low interest rates and credit losses, with more than half of dividend-paying financial stocks trimming outside the US, including UBS, AXA, Deutsche Bank, Barclays, SEB and Westpac, and Capital One and Progressive in the US.
Consumer discretionary, meanwhile, suffered from falling demand, leading to cuts in companies like Adidas, Gap and Nissan. Industry has been hit by declining economic activity, which explains the cuts at Raytheon, Komatsu and Vinci. Real estate was another badly hit sector as offices and commercial space closed, leading to cuts in companies like Voranado, Mitsubishi Estate and British Land.
Utility stocks, which were market favorites in previous years for their high yields, fell in anticipation of lower power consumption by industrial and commercial customers, prompting Centerpoint Energy, EDF and Korea Gas to cut payouts. Also the high-tech sawing sector – for example Western Digital, Electrolux and SK Hynix.
Sorting out dividend cutters
Was there a way to avoid the 2020 dividend disaster? We tested two screens used by Morningstar’s dividend indices: Economic Moat and Distance to Default.
A company with an economic ditch around its business has a sustainable competitive advantage that should allow it to maintain its profitability, and thus dividends, too. The graph below shows that companies with a wide economic ditch have held their payouts best, except in emerging markets, where five out of seven companies with a wide economic ditch are cutting. In Canada, companies with large or narrow moats do not cut their payouts. The five wide moat U.S. stocks that should cut dividends in 2020 were Walt Disney, Wells Fargo, Boeing, Harley-Davidson, and Blackbaud. Even within the ailing energy sector, several moat companies like Total, Exxon, and Enbridge made sustainable dividends.
The other dividend screen tested was Distance to Default, a quantitative measure of financial health.
Morningstar’s Distance to Default metric ranks companies based on the likelihood of distress, using option pricing theory to estimate the risk that a company’s assets will fall below the sum of its liabilities. Balance sheet data, including short and long term liabilities, is an important input. Likewise, market-related information. A company’s equity value, especially the volatility of a company’s equity, can be a previous indicator of financial distress and reflect deterioration long before it shows up in financial statements. If a company has a shaky balance sheet, struggles with solvency, or is volatile due to questions about its long-term profitability, future dividend payments can be at risk.
As shown in the graphic below, the Distance to Default measure was also an effective predictor of dividend cuts in 2020. By dividing the universe of dividend payers into equal bands (quartiles) by their Distance to Default values, companies with stronger financial health were able to do so more often base their payouts worldwide. Several wide moat stocks that cut dividends in 2020 were weeded out by the Distance to Default metric, including Imperial Brands, Anheuser Busch Inbev, Harley-Davidson, and Boeing. Distance to Default also featured dividend cutters like Canada’s CAE, Japan’s Komatsu, JD Sports from the UK, Australia’s Westpac, China’s Everbright Securities and Heineken from the Netherlands.
Address shared payers selectively
Income investors do well to remember that dividends are not guaranteed. Holders of common stock do not have the kind of property rights of a company that holders of debt securities have. Stocks with juicy returns may be tempting, but they often belong to companies with fundamental problems that then experience financial deterioration and price declines. Dividends can be cut at lightning speed, as in 2020, 2008 and at many other points in history.
Dividend paying stocks have a long and impressive history of providing investors with not only income but also total returns. But they are best approached selectively. Companies that are able to maintain profitability and are financially sound because of an economic ditch are best positioned to maintain their dividends. Stock investors who prioritize income above total return can end up sacrificing both.