The Investment Association (IA)’s decision to suspend its yield requirements for equity income funds is “bad news for equity income investors”, for whom the worst is yet to come, according to Fundsmith’s Terry Smith.
The IA said last week that it would not remove funds that did not meet the yield hurdles it sets for constituents of its UK and Global Equity Income sectors as it looks to guard against dividend cuts and cancellations caused by the coronavirus crisis.
Funds in the IA's UK Equity Income sector must deliver a yield in excess of 90% of the yield on the FTSE All-Share every year, and exceed the yield on the index on a three-year rolling basis.
Writing in the FT, Smith slammed the existing rules as rules "not… exactly stringent to begin with", noting that while the IA was "to some extent… just acknowledging reality", its decision was "bad news for equity income investors".
However, Smith, who runs the £18.3bn Fundsmith Equity fund, went on to claim that "the really bad news for equity income investors is yet to surface", with dividend cover on the 20 largest yielding UK blue chips standing at just 1.3 times.
Smith explained: "Over time, dividend cover for most businesses cannot be sustained at 1.1 times to 1.3 times, as most of them need retained earnings in order to grow. An average cover of two times is more normal.
"I would suspect that the boards of companies which have passed the dividend will indeed not be allowing a good crisis to go to waste and will return with a much smaller and more sustainable dividend which will mean much lower yields for equity income investors."
Smith suggested investors would be better served investing "for the highest total return you can achieve and sell whatever shares or units you need to provide cash".
"I realise that for many investors the idea of realising part of their capital to provide income is anathema. So what to do," the manager asked.
"If you insist on investing for dividend income, consider investing alongside a family which founded and has control of a public company. Out of the 47 stocks in the Stoxx Europe 600 that are ‘family influenced', only three have cancelled or postponed dividends.
"Very often these extended families, descended from the business founder, rely on the dividend income from the family business.
"The chief executive of one of the family controlled companies we invest in at Fundsmith says his first piece of advice from the patriarch of the family was to never cut the dividend. Investing alongside them can help to preserve your income too, and in this market environment you may get some attractive opportunities to do so."