Background: The dividend yield of Merchants is 6.8%, significantly higher than the UK Equity Income sector average of 4.8%. Meanwhile, the company can demonstrate an enviable record of progressive dividend growth; the dividend has increased for 38 consecutive years, a period encompassing many crises, rising from just 2.1p/sh in 1982 to 27.1p/sh in the last financial year. Yesterday, Merchants announced a 1.5% increase in the first interim dividend, but warned that income will be significantly lower this year and probably next. Against this backdrop, Merchants highlights that the revenue reserves represent more than one-year’s total dividend payment and will be used to cover any shortfalls.
Investec view: A very high dividend yield has generated strong retail demand for Merchants Trust and has resulted in the company trading on a premium rating in the past couple of years, at a time when many of its peers have come under pressure. This has enabled the company to issue 10.2m new shares, thereby improving marketability and reducing the ongoing charge.
However, investors should be aware of the perils of reaching for yield. A high yield has been a consistent feature, but long-term dividend growth has been anaemic. Meanwhile capital performance has been poor with the NAV total return lagging the FTSE All Share by an annualised 1.8% over five years. We believe a key driver of these two shortcomings is an unrealistically high portfolio yield requirement, which impacts portfolio construction and stock selection. Also, an apparent need for high gearing levels increases the risk profile.
Even before the pandemic, storm clouds had been gathering over UK equity income managers who had become increasingly dependent on an ever-decreasing number of stocks and sectors, with dividend cover increasingly threadbare. However, while the sector has been building revenue reserves for a rainy day, a super cyclone has hit. UK dividends are predicted to fall 40% this year and are not expected to recover to 2019 levels for some years, while many companies may choose to rebase dividends at more sustainable levels. IHS Markit forecast that even by 2022, UK dividends will be c23% below 2019 levels.
This bleak scenario will impact all UK equity income managers, but we believe its effects are more acute for Merchants. A high portfolio yield requirement already placed significant constraints on portfolio flexibility, but this is likely to be even further restricted in this environment.
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