11 July 2019
Beware the weak bearing gifts
The dangerous allure of dividends
by Frank O’Nomics
The old adage that something can be too good to be true applies very well to investments. News that BT is likely to cut its dividend follows on from a number of high profile casualties earlier this year, notably M&S and Vodafone who both announced 40% cuts in their payouts (the former the first for 10 years, the latter for over 20 years). Those who have been increasingly attracted to equities because of the income that they generate might reasonably be starting to get a little worried.
Yields on government bonds are near record lows with 10-year gilts offering just 0.75%. The returns on bank deposits, an altogether riskier prospect, are similarly paltry. Our avaricious appetite is then whetted by a 4.3% dividend yield on a FTSE 100 equity ETF, which looks stellar by comparison. With such a backdrop the recent performance of equities isn’t hard to understand. Nevertheless, while demand from pension funds and insurance companies may have been very supportive, it has taken individual investors some time to realise their attraction. Data last week showed UK equity income funds registering net inflows in May for the first time since April 2017. Clearly there has been a lot to worry about that had been pushing investors into bonds and cash. The change in flows has, it seems, not been a change in confidence (quite the reverse according to recent surveys) but more due to the income relationship between equities and safer assets reaching a point where the risks look worth taking. The big question is – will equities actually continue to deliver those attractive levels of income? The answer is – probably not.
The first question investors should ask is: why is a share offering such an attractive yield? Often this will be because the market does not expect the company to be able to sustain its dividend. The danger is that you buy a stock with an historic yield of say, 5%, only to see it cut its dividend by 50%. Not only will your income from the investment be halved, the stock price is also likely to fall due to the poorer outlook for the company’s prospects and the market moving to keep the yield at an attractive level. It helps to look at a company’s dividend cover ratio before investing. If the company’s income could have paid the dividend twice over we can have some confidence that this will be sustainable. Once that cover falls below 1 the company is paying dividends out of its reserves, which is clearly unsustainable. Take for example Glaxo, which has been paying 80p per year in dividends for a number of years, which currently gives an annual yield of almost 5%. However, at times it has paid 80p while earning only around 75p per share in income, which means that either it will have to increase its levels of income or soon no longer be able to support the payments. Glaxo is a well-run business but the high dividend payout ratio will be a constraint on the share price.
The alternative approach which many of us prefer is to leave the assessment of individual stocks to a professional fund manager. Looking for a high yielding investment trust, holding a portfolio of carefully selected equities would seem to make sense. A recent review showed that there are now 30 investment trusts offering yields of over 4%, against just 13 two years ago. This again is a development to be wary of, as it may be indicative of a trust that is under some pressure and paying dividends out of capital in the hope that the gains generated by the rise in prices over the last few years will continue to happen.
This may be the “light bulb” moment. If some equities are looking for continued economic growth to be able to sustain a high dividend and the managers of equity investment trusts need stock prices to rise so that they can pay dividends, we may be close to a perfect storm if there is a sharp slowdown. Pretty well all of the recent UK data for GDP growth overall, industrial production, retail sales and property sales suggest that the current growth rate is sluggish at best and we may well be at the start of a recession. In short, the rise in equity markets is at odds with the economic evidence.
Don’t get me wrong; dividend cuts may not necessarily be a bad thing. In many respects a company that is happy to sit on large amounts of cash that it is not investing for future growth may highlight unambitious management or an industry that has gone “ex-growth”. Such companies will struggle to sustain their value and the compensation of a high level of income is unlikely to offset the capital loss. Perhaps more importantly, companies sometimes have to sacrifice or postpone their dividend objectives to take advantage of opportunities. Vodafone cut its dividend because the money was needed to acquire Liberty Global and to build 5G networks, while BT has been softening up the market to expect a dividend cut so that it can expand the UK fibre broadband network. Arguably both of these moves are positive for investors in the long run.
All of this needs to be seen in context. Despite the high profile dividend cuts, FTSE 100 dividends overall are expected to rise by 3% thus year. This is much worse than the 15% seen last year, but it is still at least a positive number. Nevertheless, when looking at the yield on equities it must always be remembered that this is a historic figure. There is a real danger of falling into a dividend trap, and judging by the more recent economic indicators, there are more of those traps to be sprung.