The dividend is often called the ordinary dividend, but there is nothing ordinary about it. There is no other piece of information that a company can give to investors, which could more accurately reflect what that business really thinks about its current state of health.
Principally, this is because companies find it very hard to cut their dividends. It is the walk of shame for any board and executive management to cut the dividend – it is a last resort, and rightly so. By contrast, companies that choose to sustain and grow their dividends, are doing so in the knowledge that they are creating a bigger burden for the future – they need to be confident in the sustainability of the business and its future growth prospects, in order to do so.
This does introduce a problem too, however. The difficulty that boards and management teams have with dividend cuts, can lead to some ambiguous behaviour. Sometimes companies will go to great lengths to avoid a dividend cut and this simply stores up trouble for the future. This is where judgement comes into my investment process – I have to make judgements about the sustainability of a company’s dividend which may be at odds with what a management team is saying.
Within the UK stock market, examples of this can currently be found in the oil & gas sector. I believe that both BP and Royal Dutch Shell have unsustainable dividends that are being financed by a combination of debt and asset disposal. In effect, these companies are liquidating themselves rather than facing up to the need for a dividend cut. The only thing that can save them from that eventuality, in my opinion, is a return to sustainably higher oil prices – something that I think is very unlikely to happen. In short therefore, although I know this is a contrarian view because these are widely held shares, particularly by income funds, the oil majors are an unattractive investment proposition while the threat of a dividend cut hangs over them.
Instead, my focus (for the Equity Income Fund and the new Income Focus Fund) is on identifying businesses that are attractively valued and capable of delivering sustainable dividend growth in the years ahead.
There is a simple reason for that focus, which is clearly evident in the chart below. Reinvested dividends have formed a very significant part of the long-term return delivered by equities.