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29 July 2019

Unsustainable dividend yields – the canary in the coal mine?

It is accepted wisdom that a company that has fallen to a low ebb will have seen its dividend yield spike. The prospect of being paid to wait until the share price re-rates can often be attractive, however, should this also be a warning as to the real value of the company?

The dividend sustainability of many popular UK income stocks has been a continuing concern, and should be a warning to investors about the dangers of chasing yield in what is a highly-concentrated UK market.
Carillion was a prime example to show why investors shouldn’t take high yields at face value. It was yielding in excess of 7%, sucking income seekers in before suspending said pay-out and eventually collapsing.

Some of the signs to be wary of include::
  • Very high pay-out ratios
  • How much of a company’s earnings are being paid out as dividends
  • Low dividend cover of less than one (number of times dividend paid out of earnings)
  • Dividend being funded out of debt
In general terms, the outlook for UK dividend investors in the first quarter of 2019 is looking rosy as Link Asset Services’ Dividend Monitor confirmed pay-outs were up 15.7% year-on-year. What is likely to be a reasonable level of dividend yield? The investment industry tends to view 4% as a key level but the yield for the FTSE 100 index in 2019 is at 4.45%, higher than the usual level.

Shares that are yielding above 5% might well be struggling with head winds that make them unsustainable. So, what happens in these circumstances? – usually a cut or suspension in the dividend which has the effect of causing a re-rating of the share price, leading sometimes to significant falls.

A prime example of this was Vodafone which was, at one point, yielding over 9%. However, in mid-May it cut its dividend by around 40%, bringing it down to a current yield of around 6%. However, the share price suffered with a fall of c37% compared to a 7% fall in the FTSE 100 index over the same period. As to the future for Vodafone, it is very much linked to how the freed-up cash flow is used to pay down debt. This should give the company the opportunity to continue to expand its growth in Europe and the ability to invest in 5G network expansion.

Assessing free cash flow can be a positive sign of a strong dividend, especially as it considers how much money is left over, after allowing for all business expenses including interest on debt being met. If the figure is positive and the dividend is paid out of this excess, then that is a comfortable position.

Investors should not be seeking dividend yield per se, but should be reviewing a company’s financial position, to ensure that there are no nasty surprises ahead. If the dividend looks unsustainable, with no positive sign of significant changes to profitability, it could be a sign that the stock is a value trap and that the share price is heading for a fall.

Derek Gawne, Head of Office, Liverpool

Ends

Please note, investments and income arising from them can fall as well as rise in value and you may get back less than you originally invested.
 
 
 
 
Unsustainable dividend yields – the canary in the coal mine?
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