The big problem with some high-yielding shares is that the yield is a function of a dividend that isn't safe. How do you spot shares where the yield is ephemeral? Evolution's Mr Stewart has taken a suitably pragmatic view in his analysis of dividend stocks.
He's conscious of further dangers to dividend payouts, and argues that it won't be until later this year that there can be any certainty that earnings for 2010 can be forecast with any degree of accuracy. "Imagine the profile of the year," he says, "analysts plug in first earnings revisions for 2010 in March. Numbers start trickling down over the summer, and then in September and October, management starts offering proper guidance – and that's when numbers really start coming down."
He says that forecasting is more difficult for consumer-focused businesses like retailers, who make most of their profit in the final months of the year, especially as the outlook for consumer spending remains so uncertain. "What guidance can they give out if they have no visibility themselves? Buying the numbers now would be, in our view, a little bit too early."
In particular, he's worried that expectations of a V-shaped economic recovery are misplaced. "There's no evidence in history of a V-shaped recovery, so the chance of it happening this time is low and we would expect a W shape where the direction and leadership changes. This may be a consensus view, or is it just common sense?" he says. "When you're at the bottom, economic numbers and surveys get a bit volatile. People will grab onto any green shoots that are out there, any turns in sentiment. However, they do stall out, and you tend to find you get another fall. It may not test the previous lows, but it's not evidence of a sustained recovery."
That said, he's confident that the dividend cycle is about to swing upwards once more, and if more dividends are now safe than endangered, it's a good time to be chasing shares that offer a secure dividend yield. Mr Stewart defines 'secure' according to levels of dividend cover. "At the bottom of the market we're looking for cover of at least two times, because if earnings are stressed, there's more security of the payment coming through," says Mr Stewart. He points out that investors were buying shares with 1.5 times cover at the top of the cycle, which meant they were stretching to pay the dividend, even when earnings were at their peak.
National champions - the ultimate safe dividends
Being a national champion isn't what it used to be. Look at BT, for one, forced into an embarrassing dividend cut this year after disastrous NHS contracts run by its Global Services division led to massive write downs. In the age of globalisation in the UK's ultra-free market, no company remains sacrosanct. Even so, says Mr Stewart, many of the UK's blue chips are still worthy of the tag, and benefit from the trappings that their national champion status brings.
The main benefit is that financing is rarely an issue – put simply, everyone wants to lend to them, because they know that their incumbent market positions mean they generate huge cash flows and will be able to pay them back.
"They're really secure, but bankers want their other business as well. The institutions in their locality feel obliged to do business with them," points out Mr Stewart. It also means that, in the main, their dividend payouts are safe. "Vodafone is a great example. It's exposed to the consumer but earns £5bn of free cash flow a year – it's going to be able to pay the dividend."
Oil companies BP and Shell, are the same, he says. "People say, what about the oil price? Well, they just stop taking it out of the ground. They're still selling it all round the world, oil is still being bought. They just stop the capex, just slow it down. That saves more than they've spending on the dividend."
There are a few setbacks from which such titans cannot recover – witness the Shell reserves scandal, or the enormous costs associated with BP's Texas City refinery explosion.
"They key thing is they're going to come through the cycle. They may be having a tough time now but they'll get through. These names will carry on." And so, the theory goes, will their dividends.
What could derail a dividend?
In an ideal world, profits and dividends would climb onwards and ever upwards, and companies would pay out all of their spare, and plentiful, free cash as dividends. In reality, dividend cuts can strike even the biggest companies, and even so-called defensive shares aren't entirely immune.
"You can never completely get it right," says Mr Stewart when asked the 'million dollar question' of how to spot safe dividends. “There are always micro issues that come up. You can have a perfectly well run company that is forced to cut its dividend because of what previous management had done."
Debt/creditors: Many companies built up far too much debt during the boom years – in fact, the rapid expansion many achieved would not have been possible without access to cheap credit. That age of excess is now well and truly over.
"For the majority of companies all around the world bank lending is frozen," says Mr Stewart. For those still able to borrow, but needing to renegotiate facilities, rates have moved noticeably higher – and in some cases, like that of DSG International, whose creditors imposed dividend cuts as part of renegotiated terms. Higher borrowing costs naturally incentivise companies to pay down debt anyway, either by selling assets, diverting cash from capex or dividends or by tapping shareholders – 'the lenders of last resort' – for cash. And the logic of equity financing means that capital raising is often accompanied by a dividend cut.
Rights issues: The 'dash for cash' has dominated the markets for the last few months – companies have asked shareholders for tens of billions since the start of this year, and there is a very real possibility that companies may not have asked shareholders for enough and will need to extend the begging bowl once again. That's proved a real problem for dividend seekers, as Mr Stewart points out. "We have seen many rights issues over the past 12 months and I think every single one of them has carried a dividend cut. Why on earth would a company short of cash take money in from investors and immediately pay it out again?"
As an income specialist, Mr Stewart in fact disagrees with his own rhetorical question, arguing that investors are not negotiating good enough terms in rights issues, and should receive a risk premium in the form of higher dividends.
"If bank loans or debt financing is being replaced by equity where is the spare free cash flow going?" he questions.
Pensions: As we wrote earlier this year, pressure from the UK pensions regulator and the trustees of company pension funds themselves could present a serious threat to dividend payouts. Companies are under pressure to plug large deficits in their pension funds, which have opened up as equity markets have headed south. In fact, the regulator said that companies wishing to cut fund contributions so they can still afford to pay the dividend would not be allowed to do so. Recent research from Aon Consulting suggests the deficit in the top 200 final salary pension schemes has soared 80 per cent to £73bn in June alone, while the Office of National Statistics said that the overall private sector pensions deficit hit £200bn at the start of the year.
Government interventions: The UK's major banking groups used to account for around a quarter of the FTSE's total dividend payout, but their near-collapse and subsequent government bailout put a kibosh on a fair proportion of the payout. The worry now is that other industries that are either reliant on government subsidies, or looking for government handouts to help them through the recession, will also be forced to cut payouts. That's particularly apparent in the transport sector, where tensions between operators and the DfT are at breaking point. "Stagecoach is an interesting one as it tops all three of our screens, but has a major issue with government, says Mr Stewart.
Evolution's methodology
In an bid to make sure that no nasty earnings surprises jeopardise the dividend payment, Evolution Securities analyst Alex Stewart has 'stress-tested' companies' earnings forecasts by trimming 10 per cent from 2009 forecasts and 20 per cent from the following year. "The point of stress testing is that when you buy a stock you're buying into analysts' forecasts, so if I can move their estimates down and they can still pay their dividend, that should be fairly secure."
Evolution ranked companies by their stress-tested dividend cover for 2009, but also provided the stress tested figure for 2010. We've focused on the more forward-looking measure, as we believe it indicates a better degree of earnings consistency – Stagecoach, for example, which tops the table in 2009, sees cover fall sharply to 1.4 times in 2010.
We've selected six companies with cover greater than two times in both years. All six have stress-tested dividend cover greater than 2.2 times in 2009.
