Earning a crust: With Centrica, Rolls Royce, BHP Billiton and others cutting their dividend, where should investors look for income?

 
Will Railton
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Diageo, which owns the Johnnie Walker whisky brand, has increased its dividend "progressively" for a number of years (Source: Getty)

As central banks have pushed down interest rates, income has become ever harder to find. While returns on cash savings have remained low, dividend-yielding stocks have looked like a source of stability. But now, trouble in the global economy is forcing reliable dividend payers such as Centrica and Rolls Royce to slash their payouts. Companies like Rio Tinto and BHP Billiton, which had assured investors that every dividend payment would be bigger than the last, are being forced to renege on their promises.

“We are in a more challenging dividend-paying environment in 2016, compared with 2015,” says Jane Shoemake, investment director for global equity income at Henderson Global Investors. “Some sectors are clearly under pressure where there isn’t sufficient free cash flow to pay dividends.”

The problem for investors is: income matters. Reinvested dividends can boost your total returns significantly over a long period. And many retirees rely on regular payouts as a stable source of income. In late February, research by the Share Centre revealed that 70 per cent of investors are seeking income from their savings, either as a goal in itself (15 per cent) or because they want to balance the growth in their portfolio (55 per cent). So what do you need to know when it comes to finding income in the current environment?

Concentration

The base of dividend provision is shrinking. In the UK, Germany, France and Australia, more than 70 per cent of dividends are now paid by just 20 companies, and within those markets dividends are disproportionately linked to certain sectors. Before the financial crisis, banks were the big dividend payers. Then it was the commodities firms. “Oil and gas account for almost 20 per cent of FTSE 100 dividends, and mining counts for around 10 per cent,” says Shoemake – two sectors which are now under serious pressure given low commodity prices.

The key to sustainable income may lie outside the UK. “As the threat of a dividend cull on the home front lingers, going global will add some much-needed insurance to your portfolio,” says Maike Currie of Fidelity Worldwide Investment. She recommends the Fidelity Global Dividend fund, whose steady performance and attractive yield sets it apart from poor performers in the sector. Currie also suggests the Invesco Perpetual European Equity fund, which taps into the European dividend pool. “It is significantly larger than the UK’s, with a greater spread of stocks and sectors to choose from,” she says.

But at 4 per cent, the FTSE 100’s yield still compares favourably with the 1.5 per cent offered by a 10-year gilt. So how can you tell when to buy a dividend stock?

Yield and cover

While a firm can’t control its share price, it can control its dividend, and it may continue to pay a dividend despite falling profits or heavy losses to avoid alienating shareholders. “Shell and BP account for around 14 per cent of the UK’s dividends. Any cut would be seen as a failing of the management of the company and would harm the share price” says Adrian Lowcock, head of investing at Axa Wealth. “Large companies can also look further ahead and determine if they can afford to pay the dividend on a five year view.”

For this reason, high yields aren’t necessarily a good indicator that a company will keep paying in years to come. In the first half of 2015, Rio Tinto increased its dividend payout by 12 per cent, even though earnings plummetted by 43 per cent in the same period. “A look at the dividend leaderboard shows a handful of companies offering yields which are simply too good to be true,” says Currie.

How can you tell if a dividend is going to be cut? First, take a look at the yield. “As a general rule of thumb, whenever yields are in excess of 6 per cent, this should be a warning sign,” says Currie.

Then look at the dividend cover ratio. If the company is paying dividends which are larger than its annual earnings, the “cover” is said to be less than one. This means that payouts are coming from retained income or borrowings and are probably unsustainable. “A dividend cover of 1.5 or more should give some confidence that the company can afford to pay its dividend,” says Lowcock.

Kings and aristocrats

One possible indicator of a company’s commitment to paying its dividend is the consecutive number of years it has done so.

The S&P 500 contains more than 50 “aristocrats” – resilient stocks which have increased their payments for at least 25 consecutive years, and a number of “kings” such as Procter & Gamble and Coca-Cola, which have come through market crashes and economic recessions because of free cash flow and a enduring appeal with consumers.

UK investors should be mindful that dividends from US companies paid to foreigners face a withholding tax of 15 per cent, and while the exchange rate is currently favourable, that might change in the future. The UK has its own consistent performers, such as drinks manufacturer Diageo, and pub chain Greene King, which has more than two decades of dividend growth and is yielding 3.7 per cent.

The dividend tax regime

A new dividend tax regime comes into effect in April, allowing investors to earn £5,000 of dividend income tax-free each year. But after that, yields are taxed at 32.5 per cent for higher rate taxpayers, and 38.1 per cent for additional rate taxpayers, so be wary before you venture out of the tax-free Isa wrapper or your pension. Dividends received by pension funds won’t eat into this allowance, nor will those earned from Isa shares, so you should take advantage of these tax-efficient options first.

Investment trusts

When it comes to finding income, the UK has a trick up its sleeve – investment trusts. These are public companies which have a fixed number of shares, so there’s a solid base of capital and the fund manager can invest and sell assets when they want to, and not because investors have piled in or out of the fund. Best of all, investment trusts can retain up to 15 per cent of their income every year, which can be set aside to pay dividends in rocky times.

“Investment trusts don’t have a magic wand which conjures up extra income, unless you are able to pick them up at a nice discount, but they do have a mechanism which allows them to smooth out dividends by holding back income in one year to pay in the next,” says Laith Khalaf, senior analyst at Hargreaves Lansdown. Some have been able to increase each successive dividend payment for decades. City of London Investment Trust, for example, is about to enter its fiftieth year of paying out a “progressive” dividend.

But not all investment trusts have this reserve mechanism. “It depends on how long the fund has been around and what’s happening in the stock market,” explains Currie. “But in turbulent times investing in a fund with a revenue reserve is a good insurance policy. Keep a look-out for the revenue reserve figure in a trust’s annual report. This will show you for how many years the reserves would cover the dividend at its current rate.”

Investing for income

John Laing Infrastructure Fund

Nathan Sweeney, senior investment manager at Architas, recommends this income-focused investment trust. It invests in infrastructure commissioned under the government's private finance initiative (PFI).

Under PFI, private firms are paid to build and manage schools, hospitals, ports, roads and other projects. “Contracts are often 25 years and there’s a high visibility on cash flow,” says Sweeney. “We see infrastructure as a proxy for property. And because you’re investing alongside the government, there's an additional layer of safety.” Better still, the trust invests in the project directly, and not through the equity market, so you won’t be affected by a market sell-off.

Legal & General

At 5 per cent, Legal & General's yield looks “very attractive in the near-term”, says Laith Khalaf, senior analyst at Hargreaves Lansdown. “While financial markets can be tricky for banks and insurers in the short term, Legal & General looks very well set with its focus on long-term structural growth opportunities.”

S&P Dividend Aristocrats Index

This gives you exposure to the performance of those large-cap US companies which have increased dividends for the last 25 consecutive years, including Johnson & Johnson, Exxon Mobil and Colgate-Palmolive.

Greene King

Having raised its dividend every year since at least 1995, Khalaf also sees Greene King as one of the most consistent dividend growers in the market. “With consumer incomes rising steadily, boosted by lower fuel bills and jobs growth, the outlook seems positive.” But he warns that shares in the pub chain and brewer have been caught up in the recent market volatility.

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