While an optically high dividend yield may appear attractive, if the company cuts the dividend unexpectedly, that stock will very likely underperform the market in terms of total returns. Equally, while a long track record of dividend growth can be a sign of discipline and conservatism, if the absolute level of the dividend is still low, investors do not stand to gain so materially from reinvesting the dividend that they receive.
So, how does one go about deciding whether a dividend yield is sustainable?
Investors must look closely for two things: firstly, is the dividend well covered? That is to say, can the company afford to pay its dividend based on the earnings and the cashflow that the company is generating. If a company proposes to pay a dividend of 10p per share yet is only generating cashflow of 5p per share, that is a warning that the company cannot afford this level of dividend payment.
Secondly, investors must look for positive momentum characteristics. If a stock is not favoured by the market and/or is experiencing downgrades to earnings expectations then, again, that is a signal the company is facing an uncertain outlook, and hence the dividend may be at risk.
The chart below from Société Générale shows that optically high dividend yields are often rebased down, resulting in a much lower realised income for shareholders.
Forecast vs Realised yield – UK
Source: Société Générale
In practice, there are several UK stocks which currently look very attractive from both an absolute yield point of view and also from a dividend sustainability point of view.
Take ITV, which is a great example of a stock that has returned cash to shareholders. This year, ITV added 3.5% to its ordinary yield of 2.2% through the payment of a special dividend announced at the end of February and paid in May. The company is highly cash-generative at this stage in its cycle, driven by improving ad markets, free-to-air TV revenues and growth in non-TV revenues such as online.
ITV 3.5
Although the company needs to invest continually in content and programming, its ordinary dividend is expected to be covered 3.5 times by cashflow, and hence the return of its excess cash is affordable for the company and sensible from an investor’s point of view. The stock has outperformed the market by 40% since the company announced the special dividend in February.
The insurance sector is also an interesting place when searching for sustainably high dividend payments. In the recent low interest rate environment we have seen many management teams place a very strong focus on underwriting profitability and cost cutting in order to streamline their businesses and maintain an acceptably high level of profitability in the absence of high investment returns.
Couple this with an environment in which claims have been relatively low (particularly in the absence of major natural catastrophes), and it is clear that many insurance names find themselves sitting on strengthened balance sheets and cash balances at high levels compared to the recent past. This means that insurers such as Amlin and Legal & General, for example, are forecast to pay high dividend yields (6.1% and 4.7% respectively) over the next 12 months, and we remain confident in these levels given the capital strength of the companies.
Put cash to use
Given the importance of dividend reinvestments towards total long-term shareholder returns, it would be remiss to ignore other forms of reinvestable returns to shareholders. As well as ordinary dividends, current high cash levels on corporate balance sheets mean we are seeing many instances of share buybacks and capital returns.
UK housebuilders are a great example of this. In a sector which has been boosted by government schemes such as ‘help to buy’ which assists first-time buyers in stepping onto the housing ladder, companies have seen both volumes and pricing exceed expectations.
Given the low value that land had been written down to through the downturn, margins are at long-term highs. This had led to significant debt reductions and given the low interest rate environment, refinancing has been achieved at far more favourable levels. In turn, the likes of Berkeley Group and Persimmon have found themselves with cash levels above and beyond those they need for day-to-day operations, and hence over the last two years we have seen both companies commit to returning 100% of their market capitalisation to shareholders over a ten year period.
In summary, investors should not be deceived by optically high dividend yields that may at first glance appear to be attractive investments. Likewise, stocks that have a long track record of sustaining (and in many cases consistently growing) their dividends may too appear like a safe place to invest. But combining the two characteristics and investing in stocks which have a high and sustainable dividend yield will, through time, go a long way towards helping investors to avoid the significant underperformance that often accompanies a dividend cut.
