May 12, 2020

What Happened

The COVID-19 induced recession has disrupted S&P 500 earnings, prompting some firms to test one of the most sacred contracts between companies and their shareholders—the dividend.

Year to date through May 6th, the following has occurred:

  • S&P 500 companies have announced 147 dividend increases, 16 dividend reductions and 31 dividend suspensions.
  • The 3:1 ratio of companies increasing vs. reducing/suspending dividends suggests the primary sources of dividend distress are isolated in some sectors more than others.
  • There have been $13 billion in dividend increases and a combined $37 billion in reductions/suspensions.
  • The $37 billion year-to-date drop in total dividends represents a 7.6% decline from 2019.

In this note, we clarify recent dividend actions beyond the headlines. We will review market history for context as well as year-to-date dividend actions to identify trends and sector characteristics to evaluate risks and opportunities. The recession could subject the S&P 500 to modest additional downside risk. However, this will likely be concentrated in more cyclical market sectors, which account for a relatively small portion of S&P 500 total dividends.

Background

Capital growth contributes to the majority of the stock market’s total returns over time. It also contributes to its volatility since earnings trends are usually disrupted in times of economic turmoil as we have seen in 2020. Dividends, however, have consistently served as ballast, contributing a relatively stable source of return of about 25-30% of the stock market’s total returns over time. During periods of extreme economic stress, companies’ ability to increase or sustain dividend payments is challenged.

Each recession has its own catalyst and unique impact on dividend sustainability. Dividends provided a relatively stable source of return even during the depression of the 1930s and recessions of the 2000s even though particular companies suffered. Specifically, we think the dividend risk associated with today’s COVID-19 induced recession will take a different path from that during the dotcom recession from March – November 2001 and the financial crisis of December 2007 – June 2009.

Dividends Are Reflections of the Economic Cycle

In the short term, corporate dividend actions generally reflect the prevailing economic environment despite being relatively stable over time. Two distinct examples are:

1. Dotcom Recession: The bursting of the dotcom stock bubble led to a short and shallow 8-month recession in 2001. Dividends quickly recovered after a brief 9% drawdown since tech stocks, which were 34% of the S&P 500’s market capitalization at the time, paid an anemic level of dividends. The shallow recession cast only a short-term reflection on corporate dividend actions.

2. 2007-2009 Great Financial Crisis: This recession was longer (18 months) and deeper than the dotcom recession. The market’s October 2007 record high was matched with an all-time high in earnings and dividends. What followed was the meltdown of the financials. At the time, financials were the largest sector contributor to the S&P 500 at 21%, in addition to being the largest dividend contributor. The systemic threat to our financial system intensified the breadth, severity and duration of the recession and led to a peak-to-trough 29% decline in dividends. It took four years for earnings to recover and five years for dividends to recover largely due to the impact of the financial sector.

S&P 500 Shift Toward Growth and Defensive Sectors Should Reduce Dividend Cuts Relative to the Financial Crisis

Much remains uncertain about the path to economic recovery from COVID-19, but based on observations and company dividend actions since March, an equally sharp dividend drawdown compared to the finical crisis seems less likely. Unlike the last recession, roughly 70% of the S&P 500’s market capitalization and dividend contributions come from growth and defensive sectors of the market where negative dividend actions have so far been limited. It is in the remaining sectors where we believe the risks lie for negative future dividend actions. However, at some point, opportunities could exist.

Sectors at Risk for More Dividend Cuts and Suspensions

While many companies may cut or lower their dividend to preserve cash amid continued uncertainty, we believe companies in economically-sensitive sectors are the most at risk. These companies are more exposed to COVID-19 related shutdowns and the resulting economic fallout. The risk to these sectors is seen in their forward relative earnings trends. Below are the sectors we see as the most at-risk for dividend cuts/suspensions.

The energy sector has faced a one-two punch of the OPEC+ price war earlier this year and the demand destruction caused by COVID-19 related shutdowns. The consumer discretionary sector has some of the most hard-hit industries including airlines, cruise lines, retail, automobiles and hotels. These were some of the first companies to fall victim as the global economy shut down, and we believe that many of these industries are likely to face continued headwinds, even as the global economy reopens over the next several months. The resulting global recession has also pressured earnings in industrial companies, as manufacturing rolls over, as well as financial companies which have been hurt by lower interest rates.

Evaluating Areas of Opportunity

Sustainability is one of the most important factors when looking for dividend opportunities. One sustainability metric we look at is a company’s historic free cash flow conversion rate, the ratio of free cash flow to adjusted net income. Companies that are at or above 100% free cash flow conversion historically have a margin of safety in terms of paying dividends, which is especially important in today’s environment. We also look for companies that have lower levels of debt. As earnings and cash flow come under pressure, debt servicing remains constant which constrains cash available for dividends, so companies with lower debt levels are less likely to be dragged down by higher debt servicing costs. While there are other factors to consider when looking for dividends, we believe companies with lower volatility of earnings and free cash flow, as well as, a lower payout ratio would screen as attractive for dividend sustainability.

Dividend Cuts & Relative Performance

Markets tend to price in dividend cuts/suspensions before they actually happen. In the year leading up to a company cutting its dividend, these companies tend to underperform on a relative basis. However, one year later, these companies tend to outperform. While each situation is different, this suggests the market believes that, on average, a dividend cut tends to be better for the companies in the long term and, in some cases, might even help the survival of the company.

Bottom Line

The COVID-19 recession has caused an unforeseen swift and steep drawdown in economic growth and corporate earnings that is unprecedented. Dividend actions from both current and past recessions serve as a helpful tool to develop index level dividend expectations while highlighting specific areas of risk and opportunity. We believe that companies in economically-sensitive sectors like energy, consumer discretionary, industrials and financials are more likely to cut their dividend in the coming weeks and months as they look to preserve cash. However, companies with large debt loads could also see pressure to cut dividends to shore up their liquidity. When looking for sustainable dividends in the current environment, we favor companies that have a history of growing their dividends, are less exposed to the downturn in the global economy and have manageable debt loads.

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CN2020-1082 EXP12-2020