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Reality is catching up with dividend dogs

High-yielding shares may seem tempting in a world of low interest rates, but they are often a sign of an unsustainable dividend
May 15, 2019

When the share prices of quality growth shares have been moving higher for the past decade it’s easy to say that people should not invest for dividend income. All they have to do is sell a chunk of their portfolio every year if they need income to live on. This strategy can make a lot of sense if you have the temperament – and, importantly, the time – to cope with the ups and downs of share prices, and ultimately if share prices keep on going up.

Many people who are reliant on their investment portfolio to provide an income for their daily needs may not be able to cope with a big fall in its value if they are selling chunks of it using a drawdown strategy. This is because they may not have enough time to wait for values to recover in a bear market.

Instead of investing in growth companies, they might plump for investments that can pay them a high proportion of income relative to their purchase price – a high interest rate or yield – with the reasonable expectation that this can continue as long as they need the income. In other words, the source of income is relatively safe.

Not so long ago this goal could have been met by having money in a savings account or through buying government bonds. A decade of low interest rates has meant that this is no longer possible. This has forced many people to turn to the stock market instead for their income by buying shares with high dividend yields.

This is an increasingly dangerous strategy and one that could give investors following it a big headache over the next few years.

 

High dividend yield means high risk

The stock market rarely gives away free lunches – except perhaps in a general sell-off. A share with a high dividend yield is more often than not a warning sign that something is not quite right with the company that pays it. In general, it means the market thinks the dividend will have to be cut, or that it won’t grow much. You should ignore the warning sign of a high dividend yield at your peril.

If you look at many of the high-yielding shares in the FTSE 100 at the moment, the warning signs are flashing bright red for many of them. This is because they fail the criteria required for safe dividend investing, namely:

  • They are good businesses.
  • They have growing profits and cash flows.
  • They have low debts and manageable pension fund deficits.

If we look at the 20 shares in the FTSE 100 with the highest dividend yields, we can see that in many cases they are not expected to grow much going forward, and some are expected to be cut. This is shown by the forecast dividend yields either being the same or lower than the current dividend yield. Forecasts should always be treated with a healthy degree of scepticism, but here I think there are good reasons for thinking that in many cases this outlook is realistic.

 

Top 20 FTSE 100 dividend yields

Dividend yield (%)

Yield

Forecast yield

2-year forecast yield

3-year forecast yield

Evraz

16.1

12.1

10.7

10.2

Centrica

12.6

10

9.3

9.5

Persimmon

11.4

11.4

11.4

10.5

Vodafone 

9.9

9.9

9.3

9.3

Standard Life Aberdeen

8.8

8.4

8.6

8.6

Imperial Brands

8.6

9.5

10.2

10.9

SSE

8.5

8.8

7.2

7.4

TUI

8

6.8

8.3

8.7

BT Group

7.5

7.5

7.1

7.1

Aviva

7.4

7.9

8.3

8.5

ITV

7.2

7.2

7.7

7.8

Marks & Spencer

6.9

5.9

5.5

5.5

Phoenix Group

6.9

7

7

7

British American Tobacco

6.8

7.3

7.7

8.1

Direct Line Insurance 

6.8

9.2

8.8

9

WPP Group

6.4

6.4

6.3

6.4

Legal & General

6.1

6.6

7.1

7.4

HSBC 

5.9

6.1

6.2

6.1

BP

5.8

6

6.1

6.2

Royal Dutch Shell

5.8

6

6.1

6.1

Average

8.2

8.0

7.9

8.0

Source: SharePad

 

Dividend payouts become unsustainable for many reasons. However, the chief reason is because of cash flow, or the lack of it. The worst combination is when a business stops growing or shrinks but the demands on its cash flow increase in the form of investment spending (capex), debt interest and higher pension payments. This is exactly the situation that Vodafone (VOD) and BT (BT.) find themselves in at the moment.

This week, Vodafone slashed its annual dividend by40 per cent. Its core mobile phone business is struggling to grow. Competition is fierce and even though mobile data usage is growing rapidly the amount that telecom operators can charge for this is going down. At the same time, investment costs for 5G networks are currently very high. In short, there was not enough spare cash to maintain the dividend. Now that its dividend has been cut, Vodafone may become a safer candidate for a dividend income portfolio, but the market didn’t like this and marked its shares down.

BT faces similar pressures and for me a dividend cut next year looks to be a near-certainty. After using its Openreach business as a cash cow for years, BT is now having to spend lots of money to bring full fibre networks into people’s homes. It has tried to get by with squeezing faster broadband speeds out of its old copper networks, but it has now run out of road. It also has to bear the costs of investing in 5G networks as well. Throw in a growing pile of debt and a very high pension deficit and it means there isn’t any free cash flow left to pay dividends. BT borrowed money last year to maintain its dividend. This cannot last.

 

BT free cash flow vs cash dividends paid

BT free cash flow (£m)

2019

2018

Operating cash flow

4,687

5,400

Interest received

23

7

Cash coming in

4,710

5,407

Tax paid

-431

-473

Capex

-3,678

-3,362

Interest paid

-531

-555

Cash going out

-4,640

-4,390

Free cash flow

70

1,017

Cash dividends paid

1,504

1,523

Free cash dividend cover

0.05

0.67

Cash shortfall

1,434

506

Source: BT 

 

Higher payments into its final-salary pension fund to plug its funding shortfall (the value of the fund is smaller than the promises to pay pensions to its members) saw a big reduction in BT’s operating cash flow last year. A rise in investment spending on its networks (capex) meant that more cash was flowing out of the business. This meant that BT generated barely any free cash flow and had to borrow £1.4bn to pay its dividend.

One of the golden rules of safe dividend investing is to look for companies where the free cash flow generated is comfortably more than the cost of its annual dividend – its free cash flow dividend cover is more than 1. If there is a big shortfall that persists then you should be asking some very probing questions as to whether the dividend is sustainable. In many cases it isn’t.

 

Name

FCF dividend cover

Evraz

1.3

Centrica

1.1

Persimmon

0.9

Vodafone Group

1

Imperial Brands

1.2

SSE

0.2

TUI AG

0.07

BT Group

0.05

ITV

1.6

Marks & Spencer Group

1.8

British American Tobacco

1.7

WPP Group PLC

1.6

BP PLC

0.8

Royal Dutch Shell PLC

1.7

Source: SharePad

 

If we look at free cash flow dividend cover for non-financial companies (free cash flow doesn’t tend to be used as a tool for looking at financial companies) in our list then companies such as SSE (SSE), TUI (TUI), Persimmon (PSN) and BP (BP.) look as though they have questionable dividends. Others, such as ITV (ITV), Marks & Spencer (MKS), WPP (WPP) and British American Tobacco (BATS), have dividends that look quite safe on the basis of their current free cash flows. It begs the question as to whether these companies have been harshly treated by the stock market and are in fact good income shares.

 

Getting behind the numbers

Even though I use numbers a lot in my articles, investing is not a painting-by-numbers exercise. The numbers help to tell you the story behind the company that produces them. The key to spotting winners and avoiding losers is to understand how a company makes money. This will help you more than just looking at numbers alone.

Spotting safe or risky dividend shares is about understanding a company’s competitive environment and the stability or otherwise of its profits and cash flows that come from it.

In my opinion, many high-yielding shares reflect concerns about increasing competition (M&S, Vodafone, TUI, WPP), increasing regulation (SSE, Centrica (CNA), BATS, Imperial Brands (IMB)) or a changing and uncertain industry (BP, Royal Dutch Shell (RDSB), ITV). These make investors question the ability of companies to keep on growing their profits and cash flows and therefore their dividends.

Cyclicality of profits (ITV, WPP, Persimmon) is also a concern. It is always a good idea to look at a company’s dividend history to see what has happened to its dividend payment during a recession. If it was cut during the last recession and the business has not changed enough to protect itself then there’s a good chance it could happen again when the economy turns down.

For example, ITV has built up its studios business, but is it still too reliant on TV advertising revenues, which tend to tank in a recession?

 

 

The other big issue for me is the attraction of Legal & General (LGEN) and Aviva (AV.) shares, which are forecast to offer bigger dividend yields on their current share prices over the next few years. Yet both have chequered dividend histories and are not the easiest businesses for an investor to understand.

 

Should investors accept smaller yields today for more income in the future?

One of the best ways to reduce risk and to sleep well at night is to invest in the shares of very good companies. ‘Very good’ can be interpreted in different ways by different people. In the context of safe dividend income investing, I am talking about businesses with established leading market positions, high and defendable levels of profitability and, most important of all, an ability to keep on growing in the years ahead.

This approach has been embraced in something known as the quality income approach. The main drawback with this approach is that the shares that qualify for it have become highly sought-after and highly valued. As a result, they have low yields and low rates of initial income.

But, if they can keep on growing, they may have the potential to give investors more income over their investing time horizon (preserving and growing the value of capital invested could be an additional benefit) than sticking with less secure high-yielding shares.

 

Quality shares and dividend yield on current share prices 15/05/2019

Name

Yield (%)

Forecast yield (%)

2-year forecast yield (%)

3-year forecast yield (%)

10-year forecast yield (%) at 3pcg

10-year forecast yield (%) at 5pcg

British American Tobacco

6.8

7.3

7.7

8.1

10.0

11.4

Cineworld Group

3.9

4.7

5.1

5.4

6.6

7.6

Ibstock

3.9

5.4

5.7

6.3

7.7

8.9

Forterra

3.7

3.9

4.1

4.3

5.3

6.1

Domino's Pizza

3.7

4.1

4.4

4.8

5.9

6.8

National Express

3.7

4

4.2

4.5

5.5

6.3

Britvic

3.1

3.3

3.5

3.7

4.6

5.2

Morrison (Wm)

3.1

4.6

5

5.2

6.4

7.3

Unilever

2.8

3.1

3.4

3.6

4.4

5.1

Reckitt Benckiser

2.8

2.8

3

3.2

3.9

4.5

WH Smith

2.7

2.9

3.1

3.4

4.2

4.8

James Halstead

2.6

2.8

3

3.1

3.8

4.4

Tesco

2.4

3.4

3.9

4.3

5.3

6.1

RELX

2.4

2.5

2.7

2.9

3.6

4.1

Sage

2.3

2.4

2.5

2.6

3.2

3.7

Burberry

2.2

2.3

2.4

2.7

3.3

3.8

Compass

2.2

2.3

2.6

2.7

3.3

3.8

Nichols

2.1

2.3

2.4

2.6

3.2

3.7

Diageo

2

2.1

2.2

2.4

3.0

3.4

InterContinental Hotels

1.8

2.1

2.3

2.5

3.1

3.5

Average

3.0

3.4

3.7

3.9

4.8

5.5

Sources: SharePad/Investors Chronicle

 

There are good reasons to question dividend sustainability on BATS and cyclical brick makers such as Forterra (FORT) and Ibstock (IBST), but many of the shares listed in the table below fit the criteria of reasonable to high-quality businesses with stable or growing profits and dividends that many would consider to be reasonably safe going forward.

The price paid for this safety is high, as evidenced by the much lower yields on offer. Even with growth over the next 10 years, the dividend yield on cost is not great.

For me this type of analysis highlights the problems with the choices facing investors today:

  • Pay high valuations for quality growth shares and hope they keep on growing and valuations stay high.
  • Buy cheap high-dividend-yield stocks and hope that the dividends aren’t slashed.
  • Buy expensive quality income shares and wait a long time to get a decent income from them.

High-yielding shares contain lots of risks, but so does overpaying for quality as I mentioned in my column a couple of weeks ago (3 May 2019).