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Fool's gold and golden nuggets

How to analyse and monitor UK dividends
Fool's gold and golden nuggets
  • The latest Link Quarterly Dividend Monitor suggests that the aggregated distribution from the FTSE 350 is back to circa 85 per cent of pre-Covid levels
  • Understanding how dividends are paid is important when investors are assessing yield

The Link Quarterly Dividend Monitor reports that dividends are rebounding. Payments from mid-cap stocks were more than 150 per cent above Q2 2020 and for the top 100 companies, 44 per cent. The aggregated distribution from the FTSE 350 is back to circa 85 per cent of pre-Covid levels (Q2 2019). 

These figures, unfortunately, do not paint an especially useful picture as the increase is a mash of true progressive rises, restarts from enforced cuts, recommenced payments from businesses opportunistically conserving cash and some catch-ups of skipped payments. Overall, two-thirds of businesses reduced their payment last year, plus one in 10 cancelled and it was those restarting cancelled dividends that drove around 90 per cent of the rebound. So the market’s underlying rate of dividend growth is indiscernible at this stage.

And while dividends are comfortably back in investors’ thinking, a lot of old norms have been challenged by Covid. But have the established rules on finding reliable dividend payers changed? While some sectors have suffered a major reset (ie hospitality and airlines) the same diligent steps for picking a dividend stock still apply. Smart dividend investment is today far more important for those seeking (or needing) a solid passive income now that bond returns have fallen so low. So, being equipped to make the right choice when buying for yield is paramount. What process should investors follow to make the best choices?

The classic investors’ mantra that the past is no guarantee for the future is certainly true for dividend payments, especially after Covid. A company can have had a spotless 25-year record of increased distributions but faces structural changes that make continuing that impossible. Take electricity utility SSE (SSE), where dividends rose at least in line with inflation for over 20 years but as significant operational change commenced, a cut came in 2019 and there remains a risk of further reductions. A track record is useful but should not be a sole picking criterion.

 

Reading the runes 

A quick glance at a company’s dividend yield can be a good acid test and is useful for winnowing. So what can a peek at the yield betray? 

0 per cent yield – no dividend is being paid, which can indicate a range of things. The business could be young and not yet profitable, meaning all available funds divert to growth. It could be a fast-growing business justifiably using cash flow to invest in key assets. On a negative tack, it may be impossible to pay due to lack of profit or cash flow, eg creditors or the pension fund trustees may insist on having first call on any available funds. Overall, a 0 per cent yield is tricky to interpret quickly as it can reflect polar opposites but just because a company does not pay a dividend does not mean that investors should avoid it. That approach would have meant missing out on Apple (US: AAPL), Tesla (US:TSLA), Facebook (US:FB.) and Alphabet (US: GOOGL).

3 per cent yield – this is the norm and market average. A stock with this yield is likely to sit in the growth and income bracket with good EPS growth likely to be driving a positive share price trend. The yield in this case is likely to be the secondary consideration with sector and stock trading specifics driving investment decisions. Also, a stock with this initial yield could see a higher total return over time. Take the All-Share index over 10 years: share price change alone is 53 per cent or 4.3 per cent CAGR, while the total return is 117 per cent or 8 per cent CAGR. 

Here investors should also expect higher dividend growth. Buying on an initial yield of 3 per cent, 10 years later the income is likely to have risen to nearer 5.5 per cent, keeping income well ahead of inflation. 

5 per cent yield – the steady but unexciting bracket. This is the level investors might expect from an oil company or utility business, long-established, stable, often regulated companies with few more exciting calls on free cash other than to pay it out. While a little higher initially and typically very reliable, the dividend is likely to grow more slowly than for 3 per cent stocks and there is less to drive the share price ahead. This means the total return (which is likely to be lower than from the 3 per cent bracket) could come entirely from the dividend yield and have less protection from inflation. 

7 per cent yield – things are riskier at this level and detailed examination is always required. A first check should be to see if the yield is bumped up by a special dividend that may be funded by a disposal and will only be paid once (see later for notes on specials). If the yield is all due to the core dividend, it is wise to be cautious. There is a high chance that the company is overdistributing with payments it can ill afford or making payments against a business model or market climate no longer applicable. All of this presents a risk that future dividends will be materially lowered and the yield normalise to the 3 or 5 per cent bracket. 

That said, it is possible that the yield can be sustained. The yield is as much a function of the share price as the level of the payment and there can be myriad reasons why the market has seen fit to push the share price to a low level: excessive (and ultimately wrong) concern over trading, fear of onerous regulation that does not arise, a very large single shareholder lowering liquidity which deters many institutional investors, fears that a key customer will be lost or acute short-term pressures that are not going to ultimately damage the business. On balance, it is less likely at this yield level that you will sustain the income although you may receive one or two distributions in the near term. Total return could be less than the yield.

10 per cent yield – usually the danger zone and again it is important to check for special payments. It is best to keep a wide berth with the yield this high as in most cases the market is right to have run up the red flag. Again, there are exceptions. In moments of extreme market volatility, such as after the Brexit vote in 2016, there can be opportunities to pick up good stocks at very low prices/very high yields: these opportunities are very rare, though. More typically, you are unlikely to receive this apparent level of income and there is a high risk of the share price dropping materially due to a raft of other negative issues. 

 

The common sense approach

A dividend is a surplus from annual profits and can only be expected if there is sufficient resource to fund it. In the next section we look at the core arithmetic to measure the absolute ability to pay (and keep paying) but there are broader-brush issues that may not show up in the maths that could pressure a dividend. Also cash flow and profits can often diverge significantly due to accounting conventions.

  • Emergency situations – a sudden change in business climate, shock regulation changes or an unexpected opportunity to make a large investment, ie buy a failed competitor. These tend to be short-term in nature.
  • Re-orientation to growth – new management could decide to pursue more growth, diverting free cash flow away from dividends. 
  • Core reinvestment – the assets that generate profits require regular reinvestment but occasionally additional investment is required, such as when regulations change or a facility is damaged/destroyed
  • Pension funding - many businesses still have expensive final-salary pension schemes that are underinvested. Pension trustees can, in extreme cases, demand dividend cuts until holes in the pension fund are repaired. 
  • Debt reduction – if a company has high debt it can face pressure to divert cash flow to reduce it. It may also be that some debt cannot be refinanced when falling due.
  • Headline profits not reflected in cash – this is important but often hard to spot. Profits may not produce cash as they may come from: large asset revaluations does; from a business not wholly owned; a release of historic provisions; long-term contract accounting (an issue in construction or defense). 
  • Context – negative sector specific issues and competitive positioning of the stock.
  • Environmental, social & governance (ESG) dichotomy – if this is important to the investor, it can be an obstacle as ESG is often an additional drag on cash flow. Some high-yield stocks have a poor ESG rating. 

 

The arithmetic approach

The final step is to run the ruler over key numbers and ensure there are no red flags and, running the same tests, investors can rank their potential investments. So, what to measure?

  • Dividend cover by earnings / cash flow – for both a comfortable level is 3x or higher.
  • Financial health – gearing ideally below 50 per cent and Debt/Ebitda below 3x. Interest cover can be misleading with very low borrowing rates. 
  • Forecast earnings growth – to be solid but not excessively high, ideally 8-15 per cent per annum over three years.
  • Cash conversion – how much profit is actual cash (see above), the closer to 100 per cent the better. 
  • ROCE high and well above WACC – weighted average cost of capital (WACC) is the minimum rate of ROCE to justify deploying capital. A simpler, safety-first approach can be to ensure that ROCE is at least 12-15 per cent. 

In table 1 we run through the maths for four companies with a traffic-light system to assess the quality and sustainability of their dividend: our conclusion might be that on picking dividend stocks, less is more. 

 

Arithmetic dividend assessment

 

SSE

Unilever

BAT

Ferguson

Dividend yield

5.6%

3.6%

8.0%

1.6%

EPS cover

1.1x

1.5x

1.5x

2.8x

FCF cover

0.9x

1.8x

1.5x

3.4x

Cash conversion

101%

149%

149%

196%

Gearing

190%

147%

64%

84%

Debt ratio #

6.3x

2.2x

3.6x

2.3x

EPS forecast growth

2.7%

3.3%

4.7%

9.5%

ROCE - Avg 3 yr

6.3%

15.9%

5.8%

15.0%

ROCE over WACC

1.9%

12.7%

1.0%

7.0%

     

Covid cut?

No *

No

No

No

Years of increase

1 **

5

21

10

     

ESG

56

89

84

45

     

Institutional holding

74%

70%

62%

59%

Sources: Factest, S&P (ESG scores)  * Cut pre-Covid in 2019  ** 20 years prior to 2019  # includes FRS16 leases

 

Beware of specials

Special dividends are those made in addition to core, annual payments. These are made where there has been a major change such as a large divestment or where it has become clear that there is excess capital on the balance sheet. This means the business can run just as well with less capital and can return that excess to shareholders. This may seem attractive, but beware of double counting. Shareholders already own the capital now deemed excessive and it is going to be reflected in the share valuation. If it is paid out as a special dividend, it is simply converting capital from one form to another – nothing new is being created. 

The net result typically is that the share price drops by the amount of the special payment and the investor’s net position is the same. So, it is rarely a good idea to buy a stock where the high yield is mainly due to a special payment. Surplus capital is usually better addressed by making a share buyback.