In early April 2020, as the economic and financial effects of Covid-19 and the related lockdown started to take hold of the South African economy, the South African Reserve Bank (SARB) issued a Guidance Note recommending that banks withhold their upcoming dividend declarations.
This recommendation was designed to help banks conserve their capital resources and thereby ensure they were able to both support the economy by advancing loans to corporations and individuals, and absorb losses stemming from potential bad debts, according to John Gilchrist and Mikhail Motala, fund managers at PSG Asset Management.
This was an extreme move by the regulator and one that was unprecedented in South Africa, but it followed on the heels of global banking regulators such as the Bank of England and European Central Bank, who issued similar guidelines, they said.
Investors in these banks, many of whom would have assumed ongoing attractive dividends, were faced with the prospect of a year of zero dividend income. Other corporates elected to suspend dividend payments over the next few months – not because of regulatory intervention but rather out of prudence in the wake of extreme uncertainty caused by Covid-19.
Since dividend expectations are often a key driver of share prices, providing an underpin for investors’ valuations, traditionally high dividend paying companies suffered a particularly severe sell-off in 2020, as the dividend underpin evaporated, said Motala.
A case of investor myopia
While few South African companies are expected to pay dividends this year, dividend payments will eventually resume.
“Some investors can become myopic and increasingly short-term focused when faced with large market moves or higher levels of uncertainty. However, for investors who have the discipline and fortitude to look further into the future, short-term setbacks can be a rich source of opportunity,” warned Gilchrist.
“We anticipate that certain companies will resume paying dividends as soon as next year and, in many cases, will return to pre-Covid-19 dividend levels the following year. These dividend projections incorporate conservative assumptions on the recovery in revenues – they do not rely on a buoyant economic environment, significant pent-up demand or market share gains.
“We cannot say for sure when earnings and dividends will match pre-Covid-19 levels, and the glidepath will look very different from sector to sector and company to company.”
However, if you calculate a dividend yield using the dividends companies declared before any effects of Covid-19 against current share prices, you get an indication of the level of income investors could potentially expect to earn on shares once earnings and dividends return to pre-Covid-19 levels.
Dividend yields and interest rates
Dividend yields should not only be considered in isolation, but also relative to prevailing interest rates. “To highlight the importance of the relationship between dividend yields and interest rates, consider the alternatives available to income-seeking investors,” said Motala.
“The most risk averse of these investors invest in money market funds. For a number of years, inflation has been low and interest rates have been relatively high, allowing these investors to earn inflation-beating returns from money market instruments.
“As interest rates have been cut in response to the impact of Covid-19, that real yield (interest rate less inflation) has evaporated. Short-term rates, at 3.5%, is the lowest in 55 years.”
High dividend yields combined with low interest rates could tempt investors earning paltry interest income further up the risk spectrum, thereby driving flows into undervalued, high dividend yielding equities and supporting share prices.
Being paid to wait
“We are willing to look beyond the trials of this year, of subdued earnings and dividends, to the attractive yields we believe will be on offer in a post-Covid-19 world,” said Motala.
“Importantly, these dividend yields can be achieved even if overall South African economic activity remains subdued. Attractive dividend yields mean that our funds will be handsomely rewarded while we wait. In addition, in a low yield world these dividend yields could attract additional investment, leading to a re-rating of these shares and exceptional returns for patient investors.”