Dividend cuts hurt the most

NO wonder pension funds, like that at Boots, are switching out of shares. The Barclays equity-gilt study released today will make miserable reading for those with the larger part of their savings in equities.

Over the last year the total return from equities was minus 13.8% after inflation against a positive return of 0.6% for gilts. The biggest winner was corporate bonds which produced a real return of 6% in 2001.

That is not the end of the bad news for holders of equities. Over the last two years total returns from shares plunged 21.1%. This is the worst return since the 1973-74 period when Britain was deeply mired in the three- day week, there was a crisis among the fringe banks and the stock market was on its knees.

What will be a cause of long-term concern to investors is some of the underlying data. Barclays calculates that the 10-year equity risk premium - the annual average return of equities over gilts - is in sharp decline to stand at 0.6%. A comparative measure over the last 102 years would be 4.2%.

One of the reasons why equities suddenly look a much worse investment than corporate bonds is the decline in dividends.

For decades the dividend was something that could be relied upon, come hell or high water. Not any longer. Boards routinely slash the dividend as a means of conserving cash.

Among the big players to do this in recent years have been Marks & Spencer, BT, Invensys and British Airways to name just a few.

Historically dividends have provided the lion's share of equity market returns. Without reinvesting dividend income, £100 invested a century ago would be worth just £195 now in real terms. Add back the dividend and that figure turns into a glorious £19,671 in real terms.

We now live in an age of low dividends, in which income is being sacrificed for capital returns. This is particularly the case in growth enterprises. As a result investment in shares has become a far more risky proposition than in the past.

So what are the choices? Barclays Capital notes that even cash is better than shares at present, despite low savings rates. But it sees the future (as it might as a fixed interest house) in corporate bonds. It expects companies to restructure their balance sheets to use this kind of financing.

This is possible in the Britain where bond finance is far less common than in the United States.

Barclays' conclusion is that an increasing number of pension funds and other investment vehicles will be looking at corporate bonds as economic activity bounces back from the 2000-01 downturn.

Abbey habit
ABBEY National should not be punished too hard for its Enron slip. By the standards of JP Morgan Chase exposure to the same group and the difficulties of Lloyds TSB and HSBC in Argentina, this is not a big deal.

In fact it may have taught chief executive Ian Harley some useful lessons about the dangers of highrisk lending.

It does mean that wholesale banking, where profits fell 12% to £504m last year, is unlikely to be a growth area going forward.

What is as worrying is the flaccid look of some other aspects of the business. The group may have put on £1bn of unsecured lending in its core banking business, but in a year when the consumer was on the rampage, a drop of 37% in profits from its First National finance arm is not impressive.

In its core mortgage business, Abbey has been caught by the hardline ruling from the mortgage ombudsman over two-tier standard variable rates. This is being appealed, but it is clear that the opportunities for smarter marketingof home loan deals may not be as great.

Other potential weaknesses are the insipid performance of cahoot, when compared with the electronic/telephone banking operations of Intelligent Finance at Halifax, egg and First Direct. Abbey claims a much lower cost base, but the skill of IF in cross-selling products must be worrying.

Areas where Abbey is making progress are in its push into current accounts, assisted by the shake-up of transfer arrangements, and small business banking. Both are critical in a competitive marketplace. Insurance and pensions chipped in strong profits contributions in 2001, but new business premiums were down.

Abbey will need to find some way of restoring growth. Harley and his new chairman Lord Burns clearly have their eye on the spring when takeover protections at the mortgage banks fall away.

Abbey has shown an ability to keep costs to income trending downwards and would presumably manage a post-merger growth spurt. Until then, it will be some time before the stock market gets the Abbey habit.