Value stocks’ time will come – perhaps just not imminently

Depending on how you look at it, 2023 is set to be the worst year for growth in dividends paid by UK-listed companies – or the lack of it – for who knows how long. It’s certainly worse than those weird Covid-affected years of 2020 and 2021, when dividends crumpled.

In the third quarter of 2023, dividends paid by London’s listed companies fell 8 per cent on the year to £27.5bn, according to the latest UK Dividend Monitor from companies’ registrar Computershare. As a result, the registrar estimates that payouts for 2023 as a whole will be £90.7bn, 3 per cent lower than 2022’s £93.9bn. Worse, 2023’s estimate – if realised – will be lower than the total distributed six years earlier in 2017 when £94.5bn was paid out.

It means that recovery from the Covid shock is a faltering process, obviously much weakened by all that has come along since Russia’s invasion of Ukraine, now more than 18 months ago. So topping 2019’s record payout of £104.5bn is still some years away. Even if dividends in aggregate proceed to grow at 4 per cent a year from 2024, it would still be 2027 before 2019’s figure was exceeded.

Quite where that leaves the inflation-adjusted level of UK dividends is another matter – and that is the really glum element about this year’s figures, and last year’s. Basically, as the growth rate in dividends has stumbled, inflation has accelerated, thus making the real level of dividends shrink even faster. To put numbers on this, Table 1 shows the annual growth rates for both dividends and UK consumer price inflation for successive five-year periods (so, for instance, the first row of data for 2018 is for the period that began in 2013).

Basically, as inflation rises, UK dividends also – and independently – drop. So, in the period 2013-18, the real growth in dividends was 4.8 per cent a year (lovely stuff), followed by 2.2 per cent a year for 2014-19. But in the five years 2017-22, real dividends contracted by 3.4 per cent a year and in 2018-22 the annual shrinkage rate was 5.7 per cent.

Sure, growth rates depend very much on the starting level. That means the shrinkage rate for the five years to 2024 is likely to be even worse than 2022 and 2023 since the base level is 2019’s record-setting distribution of £104.5bn. Assume – optimistically, perhaps – that the five-year inflation rate for 2019-24 is 4 per cent; if so, and aggregate UK dividends for 2024 grow by 4 per cent on the year, then the shrinkage rate for the period 2019-24 will end up at over 6 per cent.

Seen in this light, it’s little wonder that UK-orientated equity income funds have had such a miserable time of it for some years. Still, it will get better if only because for 2025 the base level will be 2020’s ultra-depressed £61bn aggregate payout. Assuming the inflation rate falls further, then real growth in UK dividends will start to look impressive – especially for those with short memories.

Even so, it prompts the question, will that prospect be sufficient to revive the fortunes any time soon of UK value stocks and their investing concomitant, equity income funds?

Let’s start with a retrospective – Table 2 and Chart 1 use total return data (ie, dividends reinvested) from index provider MSCI and put into figures and images the persistent unpopularity of UK value stocks. The chart clearly shows that around 2015 there was a parting of the ways between global equities and UK equities in general, and UK value stocks in particular. Yet we need to go back another 10 years to find the most recent period when UK value stocks were investors’ stand-out choice. In the five-year period 2000-04, defined by the post-millennial bursting of the dot-com bubble, value stocks behaved as they should during scary times, showing resilience while others folded as their popularity evaporated. Value stocks also held up decently in the following five-year periods, especially during 2010-14. Since then, next to nothing – in the past 10 years UK value has produced about half the returns of UK growth stocks and a bit more than a quarter of the returns of the (US-dominated) MSCI World index.

As to the future, it is easy to draw encouragement from what we might label ‘the Ecclesiastes notion’ – to everything there is a season etc. In other words, the world will turn and the time for value stocks will come around again. Who can doubt that sentiment – it has always worked in the past so why shouldn’t it do so again? As Ecclesiastes also tells us – or would do if he were reincarnated as an investment analyst – there is nothing new under the sun, nor is there remembrance of former things. So the vanity that favoured growth stocks will make way for the favour of deeply underrated value stocks.

Yes, that will surely happen, but not necessarily in the near future. Granted, there are encouraging background factors. For starters, UK value stocks are underrated; or they are using statistics for the MSCI UK Value index going back 12 years or so, which is as far back as data for the index’s price/earnings ratio and dividend yield is available (see Chart 2). Currently, the value index is rated at just below nine times its most recent full-year earnings while, over the whole period, the average rating is close to 15 times. True, it is possible to put a pessimistic slant on this – the current low rating might simply infer that earnings are about to fall. They may well stutter as something close to recession revisits the UK economy; but surely not to the extent that average earnings are about to be halved, which is approaching what it would take for the index’s earnings multiple to return to its long-run average.

Even then, the index’s value might well be sustained by its dividend yield. On a trailing yield of 4.5 per cent, the index is pretty much the same as its long-run average (4.3 per cent). Yet what’s encouraging – and what’s implied by the index’s low earnings multiple – is that component companies are, on average, distributing less net profit to generate a given dividend yield. In other words, dividend cover is higher than average. Currently, in aggregate, dividends are covered 2.5 times by latest net profits against an average of 1.8 times. Put yet another way, on average, profits could fall by approaching 30 per cent without the index’s dividend yield coming under threat.

That said, there is another – and pessimistic – way of looking at the value index’s dividend yield, which, incidentally, is much the same as the dividend yield for the much wider FTSE All-Share index, based on its forecast earnings. Compared with interest rates available on government fixed-interest stocks (gilts), it is low. Implicitly, that makes the certainty of income offered by gilts more attractive than the income offered by equities, which should rise – and usually does – but can fall.

Sure, it’s not necessarily that simple. In their very long-run relationship, equities and gilts go through cycles where one asset yields more than the other and vice versa. Investors used to think of the ‘yield gap’, then the ‘reverse yield gap’. On that basis, perhaps we’re now entering the era of the ‘reverse reverse’ yield gap. No matter. What’s important is that for years demand for equities was partly sustained by the near-absence of income from government bonds as interest rates hovered close to zero.

Most likely, that period is over. Interest rates have returned to what might be labelled ‘normal’ levels and pressure may well continue to force them upwards as central banks – especially the Bank of England and the US’s Federal Reserve – seek to sell back to investors the huge quantities of bonds they bought to help stave off successive crises. Without the help of economic revival, which does not look like arriving any time soon, that’s not a backdrop that favours equities; especially those associated with the low-growth industries where value stocks tend to congregate.

The strategic response is that, more than ever, there is a need to diversify income funds internationally, and not just in North American equities. However, in practical terms, that calls for investing in London-listed high-yield funds and probably in actively managed ones. The choice isn’t that great, but more of that next week.

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