Dividends may not be of immediate interest to every investor, but this might be a mistake. Over the past 10 years, FTSE All-Share dividends have formed the bulk of the market’s total shareholder return (TSR) with capital growth at c.20 per cent and total return at 70 per cent plus. Dividends should be an area of interest for all investors, not just those seeking a passive income. So what are the signs to look out for and the pitfalls to avoid when looking at dividends?
The key tells
There are many ways to check that a company will be able to fund a decent and, ideally, a growing dividend payout. There are a number of vital elements to investigate before buying an income.
Distribution policy
Many businesses state how they will manage dividends and the language used is important here. Many companies pay dividends by reference to their earnings per share (EPS), which would typically be a ‘cover’ policy. The dividend might be ‘covered’ by EPS say 2.5 to 3.5 times. At least 2 times cover is desirable. If cover is very high (>5x) there might be scope for a more generous dividend policy in future. An alternative to this is a post-tax profit split, say a third each for dividends, acquisitions and retention (for a war chest of tougher times).
Others may have a ‘progressive’ dividend policy: an intention to grow the payment every year without specifying any basis for what the increases might be. A more complex version would be to peg dividends to inflation, either to match or beat it. This can become a rod for the company's back especially when inflation spikes, as in 2022/23.
Other, companies openly say they will not pay a dividend either because they prefer to invest to generate growth. Some may need to reduce debt or, in younger tech or biotech businesses especially, they are ‘burning through cash’ and paying out newly raised capital is frowned upon. Some just wish to build up cash (Apple historically was a prime example) but this can drag on the valuation – the markets’ view is that capital should be working for shareholders and not be ‘slack’ or ‘idle’.
For Reits in the real estate sector, dividends are legally prescribed – they must pay out at least 90 per cent of tax-exempt profits. Note, however, that for Reits profits can be a relatively insignificant metric, with changes in NAV being far more important.
Capital allocation
This is the policy of how free cash flow is invested. Essentially cash can be used for internal investment (building things), external investment (buying things), repaying debt or giving to the shareholders. All of these are capable of creating value for shareholders and there is usually not a prescription of how capital is allocated – this is a management decision, which is not always right and has often caused CEOs to get the chop. Calls on the free cash can vary over time and a business can decide to shift its axis, for example to try more aggressively to grow by acquisition. This can deflect money away from dividends or share buybacks (see below) even for seemingly solid dividend payers.
Free cash flow (FCF)
This is an important measure of whether a business can afford its dividend (and all the calls on its free cash) and is more telling than EPS cover. Profits and EPS can often vary significantly from the truest performance measure, which is cash flow – how much the business gets to keep. Many reported profit figures are ‘adjusted’ or use an 'alternative measure', ignoring the likes of restructuring charges, large deferred acquisitions payments or a looming debt refinancing. It is important to see if the current capital allocation policy can be fed by the available FCF.
History
Take a look at the history but never lean fully on this for the future. A historic yield is, largely, meaningless. Some stocks have been seen as rock-solid reliable payers, but things can change. Power utility SSE (SSE) is a prime example: it had an unbroken progressive dividend policy from its IPO in 1992 until 2019, being seen by many as a 'bond proxy'. The combination of other demands on cash flow (diversification) and creeping unaffordability (the payment had become tied to inflation) has caused this stock to now twice re-base its dividend.
Growth
Actually, growth is not necessarily a factor in determining a company’s ability to pay a dividend. A growing dividend yes, but a business ticking over in steady state could be a reliable payer. Even a business in moderate decline might continue paying out alongside as its balance is solid, but your capital is at greater risk.
Bond proxies
These are (were?) stocks seen as such reliable dividend payers whose income security investors might compare with that of a bond. In practice, they are a little mythological, damaged by things such as the financial problems besetting the UK’s utility businesses (especially water), If you want the income and capital certainty of a bond: buy a bond, preferably a sovereign bond.
Dividend red flags
There are pitfalls to avoid when looking at yield investments, and there are often very plain red flags.
Don’t look back
Many stocks look attractive if you look at the historic yield, but you should never invest on that basis. Look closer at the fundamentals as circumstances can change, often materially. This is especially true of cyclical stocks.
Ultra high apparent yield – this follows on to some extent from the above. Here analysts’ forecasts and even indications from the company might suggest that a large dividend will be paid, but the market is expecting, perhaps, a profit warning and major revisions. Again, have a good look under the hood here. A good acid test is to check if the yield is higher than the PE ratio: it shouldn’t be. Some yields can stay high (Legal & General (LGEN) for example) but almost always at the price of heightened risk or a limited time capability to pay. High yields can also be found in ‘toxic’ or ‘pariah’ stocks such as oil or tobacco.
Ratios
Check if a business can really and sustainably afford to pay. If the dividend is higher than EPS or costs more than the free cash flow, be wary. It is possible to pay a dividend that you “can’t afford” for one, two or maybe even three years, but the elastic can only be stretched so far. Also, check which way the debt is moving: dividends should never be funded by debt or by robbing other capital.
Cycles
Cyclical stocks can periodically be attractive income stocks: the housebuilders are a prime example. Has this business previously cut its dividend in a down cycle? History usually repeats itself. Also, be wary of special dividends paid by cyclical businesses (see below).
Changes
businesses do not stay the same forever. New management teams can focus on different things: oil companies working on green energy, Amazon shifting from retail to cloud computing or Netflix moving from physical products to streaming. This can easily upset a once rock-solid dividend expectation, trading income for hoped-for growth and capital gain. Business model change always requires close assessment. Another change can be to move from cash dividends to share buybacks – these favour larger institutions over private investors and shift the TSR towards capital gains.
Not so ordinary
The normal dividend paid by a business is known as the ordinary dividend, but there are some that are less than ordinary.
Special dividends
This is where a business has surplus capital and can think of no strategic use for it (capital investment or acquisition) and instead will pay it out to shareholders. This is often presented as a virtue but can also be seen as a lack of strategic focus. If capital is truly surplus, a share buyback is a better option (it will create a permanent EPS boost, cheaper ongoing dividend and so on). A problem with ‘specials’ is that shareholders are being paid a block of value they already own, meaning that often the shares lose a capital value equal to the special. If you want to buy a stock just to harvest special dividends (and some companies will publish years in advance the extra payouts they intend to make), be prepared to lose capital and potentially a lot of your TSR.
Cyclical dividends
As with cyclical profits, some businesses and industries have feast or famine dividends. Cyclicals tend to make excess profits when their market is swinging up and as these are often very mature businesses with usually limited scope to expand or acquire, excess profits are likely to be paid out. These businesses do not need to hold ‘rainy day cash’ and are not really taking any financial risk in giving its excess funds away. However, the often high yield is transitory, the share price is volatile and these are stocks to be traded, not held across the long term.
Preference dividends
Pretty rare these days but this is a different equity class, closer to a bond, that pays a fixed dividend and ranks higher than the ordinary dividend. If times are tough and ordinaries can’t be funded, the ‘pref’ either has to be paid or ‘rolled up’ and paid later. Some examples include the Croda 6.6 per cent cumulative or the Aviva 8 ⅜ per cent pref. One caveat: these are fairly illiquid and might be hard to trade.
Can you have it all?
Is it possible to hold a stock that pays a decent dividend and gives capital growth? Largely these are opposite attributes, but it can be possible to have both, albeit not usually for the long term. A steeply rising stock price and high dividend yield are most often cyclical phenomena.
However, there are what the market classifies as ‘growth and income’ stocks, and as the name suggests you might expect good capital appreciation from growing profits plus dividends that are likely to grow in line. This might involve accepting a lower initial yield, but the yield received later can be significant against your initial investment.
Take 3i (III). Today it yields just 2 per cent but if you had bought this five years ago, around 70 per cent below today’s price, your income this year would be around 7¼ per cent on your in-price: in addition, your capital growth would have been above 200 per cent. This may not repeat going forward, but a relatively low yield today should not be an automatic turn off if the growth prospects are strong.
Investment trusts
When looking for dividend income, many investors find the investment trust sector a good location. While some may find this area daunting, there are some very useful tools from the official representative body called the Association of Investment of Investment Companies (AIC) (www.theaic.com). Here investors can list, filter and sort all investment trusts by size, investment profile, yield, TSR, dividend growth, fees, the premium/discount on which they trade and so on. Naturally, further research is recommended to ensure suitability, but this is a very useful tool when searching for what is often good quality income.
The site also lists the sector’s ‘dividend heroes’, 20 trusts that have increased their dividend for more than 20 years (the best has a 57-year record), plus another 33 that have a 10- to 20-year record. Overall, you can do a lot worse than looking at the trusts sector for reliable income, but the ride can often be rocky and investment is above average in complexity. In the next couple of articles, we will take a deeper dive into the details of several interesting income stocks.
