UVW is not as simple as ABC
As each day passes there continue to be economic consequences to the necessary social distancing measures implemented by governments around the world. With a few notable exceptions, lockdown has been a largely negative experience for businesses. Society and by extension, economic activity, is still largely structured around physical interaction of individuals in close proximity to one another (despite the development of remote communication). Therefore, it is not surprising that commercial enterprises will suffer financially when limitations are placed on that interaction. This is either because it is a fundamental feature of a service (bars, restaurants, cruise ships etc.) or is integral to day-to-day operations (such as working together in offices or factories). These limitations, whilst they persist, mean that corporate revenues and earnings are being impaired.
Such corporate revenues and earnings are of fundamental importance to the value of stock markets. However, they are not something an investor really ever gets direct access to. A more tangible feature of stock market investment for investors is the dividend income they may receive from holding shares. This is the residual income that a company feels able to distribute and typically an amount that is achievable in the future (and can be increased). The actual importance of the dividend differs between investors. For some, dividends are simply part of an overall return whilst for others they are a vital source of income to meet expenditures. The relevance of dividends also varies between companies. For those businesses with ample growth opportunities, it is far better for them to reinvest their earnings back into these opportunities but for those without an abundance of reinvestment opportunities it is generally better to return excess earnings to shareholders. Nevertheless, despite these differences, earnings and dividend distributions from equity investments are a key metric for investors to consider.
Given the recent social distancing restrictions and the ongoing detrimental impacts on the economy, it is therefore important to understand what the likely path of earnings and dividends might look like and what this might mean for investors.
In order to keep things simple whilst still relevant, I will focus on the UK equity market. At time of writing (late April) and using data from Factset, the level of earnings over the previous 12 months was £9.67 for every £100 invested in the UK market. Today, those expectations from analysts are for earnings of just £7.63 over the next 12 months per £100 invested. Our own work, which tries to strip out some of the errors typically seen in earnings forecasts, suggests an expected earnings figure of a more modest £7.10 (or a figure as low as £6.20 based on even more prudent assumptions). Using our lower earnings expectation figures as a comparison this would be a decline of around 25-35% compared to the previous 12 months. This prediction would be consistent with our view that the effect of the lockdown will effectively wipe out 3-4 months of corporate earnings, i.e. severely reduced earnings for 2 months followed by a gradual recovery. To illustrate how quickly expectations changed, prior to the economic lockdown (as at the end of February) earnings for the next 12 months were estimated by analysts as in excess of £10.
So what does this mean for dividends? As one might expect, distributions by companies to shareholders generally follow the path of earnings. As a guide to how dividends might behave in relation to earnings we can use the last great disruption in corporate health that occurred during the 2007-09 Great Financial Crisis. Based on this, if earnings were to decline by 25-35% and dividends behave as they did in the last financial crisis we would expect to see dividend distributions decline by around 20-30% which can be illustrated in the same way as earnings were above. Over the last 12 months, the UK equity market distributed £5.22 for every £100 invested. Over the next 12 months for the same amount invested we would now expect those distributions to fall to somewhere between £3.60 to £4.20. Again, this broadly tallies with the recent postponements and reductions in dividends we have seen, some of which we expect to be wholly or partially paid out later in the year. Had the Covid-19 pandemic not occurred, one might have reasonably expected these dividends to have been in excess of £5.40 per £100.
The next key question is to look beyond the next 12 months and to consider where we think earnings (and dividends) will go from that point onwards. In the early stages of the economic lockdown, the general consensus was that there would be a sharp fall in activity followed by an equally sharp recovery once it was lifted. This would have been a ‘V’ shaped recovery and something equity investors would have considered a blip that would soon be behind them. However, as the lockdown has continued, it has become clear that any easing of lockdown measures will need to be a gradual process – a medical solution to the virus is still some way off and the rate of infection could easily become uncontrollable if the process of easing the lockdown is rushed. In turn, some of the short term economic effects on businesses are now in danger of becoming more permanent with many small businesses possibly not reopening at all post-lockdown and many larger companies opening with reduced staff levels. Consequently, the initially optimistic view of a ‘V’ shaped recovery has recently given way to a more sedate recovery forecast , or a ‘U’ shaped recovery. If the virus proves to be harder to tackle and we see a second wave of increasing infection levels post lockdown, then there could even be a ‘W’ shaped recovery as temporary lockdowns become a periodic necessity.
Of course, there are endless letters and symbols one could use to speculate on the journey the economy might take in the future but the uncertainty of many of these paths could be highly damaging to businesses. For now, however, our view is that we expect to see a ‘U’ shaped recovery (although what is less clear is how long it will be until we do start to see a sustained recovery – in 12 months’ time will we be on the right, middle or still on the left hand side of the U?).
Another important thing to note is that in a recovery, the improvement in dividends will be seen later than we see an improvement in earnings, as companies will need to see consistent growth in earnings before being comfortable in reinstating or increasing dividend payments to investors. Secondly, companies will shore up any weakness in their balance sheets before electing to distribute cash. Another critical factor investors need to be aware of is that equity prices (as we have recently witnessed) typically change well in advance of any actual change in the profitability of businesses. Historically equity prices have anticipated a change in earnings by around 9 months and a change in dividends by around 12 months. Therefore, it is also likely that by the time earnings and dividends do begin to recover, equity market prices will have already moved much higher.
As ever, we will regularly monitor these and other factors. More importantly, we will also focus on the relationship between the factors and any inconsistencies we identify between them. Performing such analysis will inform how we best manage your portfolio within the context of your investment objectives and will help us to navigate through the current difficulties and into recovery, whatever shape and however long that takes.
If you have any questions, please feel free to contact me (firstname.lastname@example.org) or your financial planner.