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The Goldilocks yield

Note that the term is now ‘income’ fund, no longer ‘high yield’, a description that is at best otiose and at worst obsolete because those companies whose shares used to yield something properly ‘high’ will no longer be able to afford dividends. Okay, I exaggerate, but it is not just because dividend payouts are set to be slashed in 2020 that the notion of ‘high yield’ is out of place. Beyond that – when, hopefully, the global economy is seriously recovering – the corporate dial will be reset for an acceptable amount of dividend that a company should distribute.

If less is to be paid out, dividends will be lower, yields will be lower, there will be less to go around even when normality resumes. All the more important, therefore, that investors should be confident their income fund holds shares whose dividends can be relied upon. Hence the focus on cash flow.

A week ago I showed that even by trawling through a pool as limited as the FTSE 100 index and then using accounting profits as the driving factor, it was still possible to assemble, several times over, the core of a portfolio that, even in the new normal, looked capable of producing an acceptable yield on sustainable payouts.

Think how much better the results might be if the search is extended to the 420 components of the FTSE All-Share index (minus investment trusts) and the focus is on their ability to generate free cash (basically, the cash profit left over for shareholders). Hence the table, which shows 10 likely candidates.

Not too much, not too little
 Share price (p)What the co can afford (£m)Amount per share (p)What that wd yield (%)F'cast div (p per share)*F'cast yield (%)
Anglo American1,8701,20797.
Wm Morrison1872189.
Bloomsbury Publishing20589.
Berkeley Group4,454261208.44.7210.04.7
Stock Spirits224188.
Carr's Group12944.
GlaxoSmithKline1,5302,61552.53.480.05.2 294529.73.310.93.7
*Forecasts based on average of City analysts; source: FactSet    

The logic behind their choice was outlined earlier this year when I explained how to stress-test a company’s ability to maintain its dividend (see Bearbull, 17 April 2020). The process is simple enough. Start with the tough parameter that an affordable dividend can consume no more than half the average free cash, weighted by time, a company has generated over its most recent five years. If that figure produces an acceptable yield – say, at least 3 per cent – that’s a hopeful starting point.

Thus, for example, in the past five years supermarkets operator Wm Morrison (MRW) has averaged £436m of free cash, which indicates that, even in a poor year, it should be able to distribute £218m. That’s 9.1p per share, which would yield 4.9 per cent with the share price at 187p. On average, however, City analysts expect the dividend for the year to end January 2021 to be just 7.3p for a 3.9 per cent yield. So where dividends forecast by City analysts are lower than a company’s apparent ability to pay, as at Wm Morrison, the payout should be fairly assured.

Obviously that statement comes with caveats. In particular, because the cash-flow measure is backward looking, it will exaggerate the dividend-paying ability of companies whose trading is being savaged by Covid-19’s collateral damage. For example, retailer Topps Tiles (TPT) has generated £12.1m of free cash a year on average, which would enable it to pay a twice-covered dividend that would yield 7.7 per cent. As it is – and for understandable reasons – its shareholders are likely to get nothing this year or next.

So when readers trawl through the full data set for the All-Share index, which is accessed via the link below, they must keep their wits about them. There are many companies whose shares would produce stupendous yields if the future was going to be like the past, but it isn’t and they won’t.

Those companies that look most interesting are in a sort-of Goldilocks bracket – not too much yield or too little, but just enough. There are three characteristics to look for:

●  Trading is likely to be relatively unscathed by current conditions, so the recent past offers a plausible guide to the future.

●  Past performance shows they are capable of generating the cash that will produce an acceptable yield. That might be a percentage point or so either side of 4 per cent, but tune your scepticism to rise in line with a rising yield.

●  City analysts forecast a dividend for the current year that will produce a yield similar to the one based on cash flow.

The 10 in the table more or less meet these criteria. They are also a well-diversified group, so they could form the core of a new-look income fund. But there is much data to be sifted yet. After a short break, this exercise will conclude later this month.