Dividend payments from FTSE 100 companies continue to soar following eight consecutive years of growth.
This means that the overall dividend yield of Britain’s largest 100 companies will be 4.9%, outstripping the 0.75% Bank of England base rate – the benchmark for cash savings – and the 1.2% on 10-year UK government bonds.
While this is certainly good news for income-seeking investors, many experts are starting to question whether companies will have sufficient earnings to cover the income to be paid to their shareholders in the future.
Are dividends sustainable?
It's important to pay specific attention to the sustainability of dividends to ensure that companies are not stretching themselves in paying them. A firm that pays a high dividend yield now is not necessarily a good investment unless that dividend is sustainable. For this to be the case over a period of years, investors would of course look for the company in question to be growing the earnings and cashflows from which these dividends are paid.
In general, however, dividend sustainability across the FTSE 100 currently looks reasonable according to Ian Aylward, Head of Manager and Fund Selection at Barclays. Across the overall index, levels of company borrowing are not high compared to the last decade.
But there are particular sectors, such as utilities, where dividends are being funded by assets being sold, or increased borrowings rather than cash flow. In contrast, the consensus of the UK equity managers that our fund research team meet with is that the banking sector appears to provide the best future potential for improved dividend payments. This is because the current stage of the economic cycle should result in an improvement in bank cashflows. This is due to a combination of factors including the end of a number of legacy issues affecting the sector (such as Payment Protection Insurance in the UK), record low unemployment, a stable housing market, and increased demand for consumer credit. All of these factors should help banks to generate more money to pay dividends. It is important to remember, however, that dividends are not guaranteed and can be reduced or cut without warning.
Understanding dividend cover
Three of the top five dividend yielding companies in 2018 were house-builders. While this is indicative of their sizeable capital return programmes, it may also hint at investor scepticism over whether the industry can maintain its currently elevated levels of profitability without the continued benefit of government assistance through the ‘Help to Buy’ and ‘Lifetime ISA’ schemes.
An important concept to consider here is ‘dividend cover’. This is the ratio of a company’s annual earnings to the amount paid out in dividends. Ideally, companies should have cover of around two, which means that the profit is double the amount the company is paying to shareholders. Persimmon, Barratt Developments and Taylor Wimpey recorded just 1.13x, 1.5x and 1.4x forecast dividend cover for 2018 respectively.
Check for ‘fake’ sustainability
A dividend cut is often regarded as a last resort and companies may take drastic measures, such as asset sales or cutting capital expenditure, to avoid taking this course of action. These steps may enable a company to escape an immediate dividend cut, but the cost could be slower growth in the future, hurting shareholders in the long run. Furthermore, borrowing more to finance dividends will expose companies to even higher risk of financial distress, making dividends even less sustainable.
Instead of just considering the amount of dividends on offer, it’s important for investors to consider how firms are financing them so that they can see how sustainable these dividends are.
The FTSE 100 Index currently boasts a total of 26 companies that have grown their dividend every year for at least the past 10 years, nine of which have grown their dividend every year for the past two decades.
While dividends, and expected dividends, are an important measure for understanding future returns it’s important to remember that they’re just one constituent in the total return of any investment. After all, if you’re looking for income it doesn’t mean you need to look only at dividends. An investor can simply sell an investment that has increased in price to create an income even if the dividend received is low. There may be tax considerations to factor in, but remember tax rules can change and their effects depend on individual circumstances.
Media attention will always focus on share price fluctuations because these are often more dramatic and attention-grabbing than gradually growing dividends. But dividends are an important feature of equity investments, providing feedback that can influence an investor’s judgement about how their investment is performing.
As the political uncertainty of Brexit rolls on, asset prices may endure an unwanted spike in volatility. Dividends can provide a stable and growing source of income. They are rarely cut in short-lived market corrections and the dividend stream is typically less volatile than the equity market. Income funds are some of the less volatile among equity funds as dividends act as a cushion in market corrections. A consistent stream of dividends may just provide investors with the right level of comfort required to get invested, and stay invested, for the long term. These are our current opinions but the future, as ever, is uncertain and outcomes may differ.