Can investors bank on FTSE 100 dividends?

The attractions of dividend investing

There are many different ways to invest. However, dividend investing has many things going for it, which perhaps have been neglected in recent years given the soaring share prices of perceived quality growth shares.

Above all else, a dividend represents a tangible return on a share that once paid cannot be taken away. The same cannot be said for share price gains, which can only be realised when a share is sold.

Dividends can not only be used as a source of income to live on, but as an investing strategy to compound in value over many years. By reinvesting dividend income to buy more shares, which in turn provide more dividend income, it is possible to build up an investment portfolio that steadily grows in value and provides more annual income – even if dividends per share and share prices remain unchanged.

The effects of reinvesting dividend income on a £100,000 initial investment

Source: Investors Chronicle

If we take an initial investment of £100,000 paying £4,000 of annual dividend income – a 4 per cent dividend yield – and assume that the share price of the investment and annual dividend per share do not change and reinvest the dividend income to buy more shares, the annual income from the portfolio increases to £8,427 after 20 years and its value increases to £219,112. All the investor has to do is exercise discipline and patience and let money make more money.

The strategy is more powerful when annual dividend income grows, even by a modest amount. Assuming 3 per cent annual dividend growth and that the dividend yield remains at 4 per cent (this means a share price of £100 at the start increases to £103 after a year of dividend growth), the process of reinvesting dividends sees annual income increase from £4,000 to £14,777 after 20 years and the portfolio value increasing to £384,215. All this is achieved without the investor adding any more money to their initial £100,000.

Like most investing strategies, it requires the necessary temperament to stick with it through good times and bad. The caveat is that this requires dividend payments to remain stable or continue to grow. If this holds, then reinvesting dividend income when share prices are falling is something that investors should welcome as the income will buy more shares and hopefully more future income.

Dividend income and the FTSE 100 

Dividend reinvestment is a strategy that is well suited to investing in index-tracking funds or exchange traded funds (ETFs). Some of these funds (accumulating funds) will reinvest the dividend income for you, less a nominal fee. Otherwise, it’s quite straightforward to set up a dividend reinvestment plan with your broker.

At the time of writing, the Vanguard FTSE 100 ETF (LSE:VUKE) has a share price of 3,195p and has paid 157p a share of dividends over the past year, giving it a trailing dividend yield of 4.9 per cent. Does this mean that the FTSE 100 could be a very good tool for dividend compounding?

Possibly is the short answer. The FTSE 100 is a much maligned index due to its relatively lacklustre price performance over many years. However, such a criticism, while being very fair, ignores the dividends that have been received by investors in it. 

In price terms, the FTSE 100 is up by just 12.5 per cent over the past five years, but is up by 37.5 per cent when dividends are included. Over 10 years, the price is up by 27.5 per cent, but total returns including dividends is 101 per cent. Yes, you could have done better investing elsewhere, but that is not too shabby a return for someone following a dividend compounding and income building strategy on autopilot.

The FTSE 100 provides just under 90 per cent of all dividend payments from UK-listed companies. Those dividends have grown strongly since the last recession in 2008.

One of the most powerful messages I take from this chart is how resilient UK dividend payments have been. It also highlights that dividend returns from shares are a lot more stable than share prices as a component of investors’ total returns.

In 2008, investors received £62bn of dividends from UK shares. Payments fell to £54bn for the next couple of years, but by 2011 they were back to 2008 levels. In 2018 £99bn was paid out with Link Group – the company that produces the quarterly UK Dividend Monitor report – forecasting £110bn for 2019.

The key issue is how sustainable these dividends are and how likely they are to keep on growing. In recent years, special dividends and foreign currency gains – the weak pound has boosted overseas profits of UK listed companies – have given a nice boost to dividend payments. If these are excluded, then Link has calculated that UK underlying dividend payments actually fell during the third quarter of 2019.

The outlook for FTSE 100 dividend payments

To answer the question on dividend sustainability and growth potential, I’ve taken a closer look at the current makeup of FTSE 100 dividends.

Top 10 FTSE 100 dividend payers

Source: SharePad/Investors Chronicle 

According to data from SharePad and my calculations, the current FTSE 100 companies are forecast to pay out £98.9bn of dividends over the next year. This is forecast to fall to £97.9bn the year after, before rising to £100.4bn the following year.

At the time of writing, the market capitalisation of the FTSE 100 is £2.07 trillion. The respective forecast dividend yields are 4.8 per cent, 4.7 per cent and 4.9 per cent. Forecasts should always be taken with a pinch of salt. The actual dividend outcome will depend on many things, including the dividend paid, exchange rates, the shares in issue, the size of special dividends and the constituents of the index.

The vast bulk of the dividend payments and the dividend yield is coming from the top 10 biggest dividend payers, which account for 56.4 per cent of total payouts. The forecast yield on these shares is 6 per cent, but it is not expected to grow mainly due because the size of special dividends being paid by Rio Tinto (RIO) and BHP (BHP) is not expected to be repeated.

This is not really that surprising. High dividend yields are often a sign of a dividend that is unsustainable or has limited growth, and that certainly seems to ring true here.

The question therefore arises, can the private investor do any better? Can they put together a portfolio of FTSE 100 shares that can give them more income than a tracker with the prospect of some growth?

I’d say it’s possible, but not without taking on extra stock-specific risk. There are lots of high-yielding shares in the FTSE 100 with a third of the index yielding more than 5 per cent, but sustainability and possible growth are questionable in many cases.

Possible 10-stock income growth portfolio

Source: SharePad

Utility companies and housebuilders offer high yields, but their dividend sustainability is questionable. Utility dividends are threatened by regulatory reviews of their prices whereas builders’ ability to pay big special dividends looks short-lived given a more challenging trading environment. Companies such as Sainsbury’s (SBRY), ITV (ITV) and BT (BT.) have chunky yields but questionable dividends, in my view.

If analysts’ forecasts are to be believed then financial companies are likely to be good sources of income growth going forward, while offering a high yield. I take on board the view that tobacco may be a dodgy source of sustainable income, but it is still predicted to defy doubters for a while yet. If you add on some lower yielding quality dividend payers such as RELX (REL), Diageo  (DGE) and Unilever (ULVR) then you can get a better income than a FTSE 100 tracker, but I’d accept that it’s not a portfolio for those with a nervous disposition.

An equally weighted portfolio of 10 shares I’ve selected offers some growth with reasonable dividend cover. The yield on cost – your income – may turn out to be better than a tracker, but not by much in the short run.

Income from equally weighted 10-stock dividend portfolio

Source:Investors Chronicle