How dividend stocks behave during a recession

While the Covid-19 pandemic is a health crisis that has shocked the world, pundits have been fretting over the arrival of a correction for close to two years now. It’s fine and dandy to have growth stocks during a bull market.

Recessions and bear markets are almost a shoo-in for long-term investing. While we will never be able to guess its exact timeline, what’s certain is that it is around the bend, particularly after an 11-year bull run since the 2008 financial crisis.

While the Covid-19 pandemic is a health crisis that has shocked the world, pundits have been fretting over the arrival of a correction for close to two years now.

It’s fine and dandy to have growth stocks during a bull market.

However when things take a turn for the worse, high-yielding dividend stocks tend to cushion’s one portfolio better.

High dividend stocks tend to be more resilient during hard times, especially when investors are no longing clamouring for capital gains, but focused more on capital preservation.

During downturns, fear and other emotions cause wild swings which tend to detach stock prices from their underlying fundamentals. Dividend stocks are far less volatile.

Nonetheless, the concern is on what happens when the earnings of a company also become terribly affected as a result of the Covid-19 pandemic, and hence the company’s capacity to pay dividends isn’t what it used to be?

After all, if dividends are paid out of cash flow, and this diminishes for most companies during hard times, surely dividend cuts are around the corner?

For example, the UK’s central bank has already forced major lenders to cease paying dividends and buying back their shares.

Shares of HSBC Holdings Plc, Barclays Plc and other lenders fell earlier this week after they cancelled their outstanding dividends and buybacks and said there would be no payments in 2020.

The European Central Bank has also already asked eurozone banks to stop dividend payments for six months.

Governments aim to keep credit flowing in the economy, and banks are at the front end of massive government support.

The economic outlook in Malaysia isn’t encouraging too.

Bank Negara has already said that the Malaysian economy is expected to see a contraction of 2.0% at its worst and growth of 0.5% at its best in 2020, compared to 4.3% in 2019, against a highly challenging global economic outlook.

Bank Negara in its 2019 Economic Monetary Review on Friday said the domestic economy will be impacted by the necessary global and domestic actions taken to contain the outbreak.

“Of significance, tourism-related sectors are expected to be affected by broad-based travel restrictions and travel risk aversion, while production disruptions in the global supply chain will weigh on the manufacturing sector and exports, ” the central bank has noted.

“The implementation and subsequent extension of the Movement Control Order (MCO), while critical, will dampen economic activity following the suspension of operations by non-essential service providers and lower operating capacity of manufacturing firms, ” it adds.

Less volatile

So what happens to dividend stocks during a recession when earnings come under pressure and the need to preserve cash takes centre stage?

Important to note is that dividends are commitments made by management teams to shareholders. This is especially for companies that already have a dividend policy in place.

In Malaysia, most of the Real Estate Investment Trust (REIT) stocks have a 90% dividend payout ratio. Brewers like Carlsberg Brewery (M) Bhd and Heineken (M) Bhd have dividend payout ratios of roughly 80% and 97% respectively.

Other high yielders include Petronas Gas Bhd with a payout ratio of more than 70%, while investment holding company LPI Capital Bhd and Malayan Banking Bhd have a payout ratio of more than 80% and 70% respectively.

Now, reducing the dividend is one of the last things a company wants to do because it often signals financial distress in the business.

“Even if stock prices are falling and investors are panicking, management teams will often try to maintain the company’s dividend so long as it does not threaten their ability to meet essential obligations, such as debt payments and investments to maintain their businesses, ” says investment website Simply Safe Dividends.

It adds that companies that pay dividends also tend to be more mature, with established customer bases and relatively stable sales, earnings, and cash flow over time.

Dividends are meant to be paid out of excess earnings as well, which means profits the company doesn’t need to grow the business.

“As a result, many companies that pay dividends often have fairly disciplined management teams and shareholder-friendly corporate cultures which balance continued growth of the business with returning excess cash to investors, ” it says.

Simply Safe Dividends says that since World War II ended there have been eleven recessions and bear markets (see chart).

The dividends paid by companies in the S&P 500 tended to be far less volatile than their share prices during these times of severe distress as well.

As dividends tend to fall significantly less than share prices, recessions can be a great opportunity for investors to buy quality companies at much higher yields and lock in superior long-term returns, it added. Malaysian companies that can significantly raise dividends during recessions

Meanwhile, UOB Kay Hian head of research Vincent Khoo says in a report said that Petroliam Nasional Bhd (Petronas)-listed companies are best positioned to significantly raise dividends that will help the government to fund the RM250bil Prihatin stimulus package.

The Malaysian government presently faces the challenge of controlling its budget deficit despite the enormous need to fiscal stimulate amid the Covid-19 economic fallout.

UOB Kay Hian’s argument is based on its screening process, which looks at government-linked companies (GLCs) with relatively more resilient cash flow, manageable capital expenditure requirements and solid balance sheets.

“In this respect, notable government linked companies (GLCs) with capacity to raise dividends in the current environment are Petronas Chemicals Group Bhd (PetChem), Petronas Dagangan Bhd (PetDag), MISC Bhd, Petronas Gas Bhd, Tenaga Nasional Bhd (TNB) and RHB Bank Bhd, ” UOB Kay Hian wrote in its April 1 report.

It has noted that among the Petronas group of companies, PetChem and PetDag had the largest capital management potential, as its analysis indicated that both companies would still have a fairly substantial net cash balances even when it stressed their cash flows.

UOB Kay Hian says low oil prices and weak petrochemical demand might dampen PetChem’s future cash flow generation but the company had high cash levels and its future capex was expected to be smaller as it was on the tail-end of the Pengerang project.

The brokerage notes that although PetDag’s FCF would be weak due to the impact of low oil prices and Covid-19 economic fallout, the company still had high cash levels to service another round of high dividend payments.

UOB Kay Hian says PetDag could afford more than 100% payout (above its 50% policy).

As for other GLCs such as TNB, UOB Kay Hian says the energy giant company has scope for further capital management, given its cash pile of RM12bil against working capital requirement of only RM3bil.

Among GLC banks, RHB has the most potential to raise dividends, with its Tier 1 capital of 16.3% being significantly higher than Maybank’s 14.6% and CIMB Group Holdings Bhd’s 13%.

“If RHB were to raise its dividend payout ratio to 70% from the current 50%, this would raise current yields from 6.0% to 7.9%, ” UOB Kay Hian says.

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