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The “dullness dividend” is the term the City coined on the back of the relative calm since the appointment of Rishi Sunak as UK Prime Minister, and Jeremy Hunt as Chancellor. Consensus is that markets are taking comfort that fiscal prudence and philosophical discipline has been restored at the top of the UK’s ruling elite. There is evidence of this dullness dividend with long-term government borrowing rates back to similar levels seen prior to the notorious ‘mini budget’, despite base rates having continually risen since as the BoE continues its battle against inflation.
On this basis, one could argue that this makes the UK an attractive place to do business – without opening the can of worms around Brexit. Thanks to the dullness dividend there is greater confidence that the status quo will be maintained and there will be no more self-inflicted shocks to the system. Uncertainty is the greatest headwind to capital investment and business activity, and the dullness dividend goes some way to smoothing these fears.
UK is trading on a steep discount
Despite relative calmness being restored, we are yet to see this reflected in the valuation of UK assets. The FTSE 250, often viewed as the barometer of domestic UK, currently trades on a forward price to earnings ratio of 10.7x. This is a steep discount to its 10-year average of 18.6x, and not far off its cheapest in 2008 of c.8x. Whilst we can debate how bad or good things may be, it doesn’t feel like we are quite in the meltdown of modern finance and capitalism that we may have felt we faced back then.
Small businesses can thrive – despite the headwinds
This brings us to the sources of shareholder returns, which are earnings growth, the multiple applied to those earnings and dividends received. It appears the risks of multiple expansion rather than compression are somewhat skewed to favour expansion for UK companies. Earnings growth is a little more subjective at the headline level in the current climate. As active small cap managers, we would argue there is always the opportunity to find companies that can grow earnings in a given economic environment. However, parking the earnings discussion, this leaves dividends. The dullest part of the shareholder return equation; pocketing an attractive dividend distribution, doesn’t get the heart pumping as much as accelerated earnings forecasts or watching an ever-expanding multiple of those earnings. Nonetheless, if we look over the longer term, dividends have been a vital part of shareholder returns.
The impact of dividends for shareholders
Since 1970, dividends have contributed 34% of the cumulative returns, and that’s excluding any impacts from compounding. This far outstrips the 14% contributed from multiple expansion which was largely attributed to the last decade and the ultra-low interest rate environment. We are currently experiencing a sharp move away from that globally, the consequence being multiple expansion transitioning into multiple compression, especially for those companies offering dazzling shareholder returns in years or decades time. Given earnings growth can be ferociously debated on its likely contribution in the short-term, it may be playing as a side act to dividend distributions doing most of the heavy lifting for shareholder returns.
We believe investors will need to switch mindsets to “jam today, not tomorrow” which is a complete reversal of that needed to prosper over the last decade. This means focusing on businesses that generate meaningful cashflows today that support dividend distributions, rather than those promising enticing cashflows in the future that are more vulnerable to increasing discount rates.
The small cap opportunity
Investors have traditionally turned to large caps or specifically UK large caps for dividend exposure. However, there are currently over 300 companies in the UK small & mid-cap space offering a 2+% yield. This is more companies than offered by the FTSE 100, S&P 500 or the Euro STOXX. Hence, this should provide a rich hunting ground for dividend seeking investors, particularly since on average it sits at a 25% discount to the above large cap indices.
Regardless, history shows that the index returns of the S&P 500 and Euro STOXX have vastly eclipsed the returns generated in the UK. This is true, but this only captures the earnings and multiple parts of the total shareholder return equation. Include dividends and the FTSE Small Cap and FTSE 250 have notched up 549% and 746% respectively over the last 20 years. This compares to 367% for the Euro STOXX and 514% for the S&P 500.
The widest pool of opportunity
All things considered, it feels like the UK is a good place to invest, especially relative to its own recent history. Yet regardless of ones view on the UK, investors in UK assets are being adequately rewarded based on the valuations they have to pay. The new economic environment suggests that dividends will carve out a larger part of shareholder returns, and the UK small-cap markets appear to offer the widest pool of opportunity to invest in dividend paying companies. This should allow active managers in a wider universe to be able to deliver a portfolio of companies that are best positioned to grow earnings in whichever macro-economic environment we face, even if there is relative calm for now.
Dividends might be rather dull, but as we have seen in UK politics, dullness can sometimes pay dividends.
Manager of the VT Downing Small & Mid-Cap Income Fund
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Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies.
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