UK investors should look further afield to cash in on record dividends

Global dividends are at a record high, but investors must pay attention to dividend sustainability.

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  1. Garry White

 

Right now, investors are worried. Major technology shares have entered a bear market, concerns over a slowdown in China are increasing and the pace of tightening by the Federal Reserve in the US is a major distraction. However, there is one significant bright spot in global markets right now that should not be ignored. Global dividend payments have hit a new all-time record and this trend is set to continue. This is good news for income seekers – but UK investors need to consider some important issues if they want to maintain their level of income.

Ten years after the financial crisis there is still a structural shortage of assets that can throw off an attractive and reliable yield. UK base rates are at just 0.75% – so the return from cash on deposit is below inflation – and this situation is unlikely to change anytime soon. Indeed, the market does not expect an increase in UK interest rates until August next year. This, combined with the Bank of England’s quantitative easing programme, has helped keep ten-year gilt yields anchored around 1.5% – yet again providing a return that is lower than the current rate of price rises. The hunt for higher returns is why income seekers have had to increase risk and hold equites instead of bonds for the last ten years. With rates now staying lower for longer than expected, there is a continuing yield gap between equities and bonds.

In the third quarter of 2018, total UK dividend payments rose 3%. This figure may seem pedestrian, but was a result of lower special dividend payments and a weakening of the pound. Once these factors are stripped out, UK payouts were up 11.1% on an underlying basis, according to data from asset manager Janus Henderson. After recent market falls, the expected yield on the FTSE 350 is now around 4.5%. This is significantly more attractive than holding bonds – and the yield on the UK index is twice the equivalent figure for the S&P 500, which stands at 2.01%. This means the FTSE 100 is high by global standards and often the index of choice for UK residents seeking income.

However, it is important to consider dividend sustainability. A key indicator of this is its dividend cover, which is calculated by dividing earnings per share by dividend per share. Investors are comfortable if the dividend is more than two times covered by earnings, but below this the sustainability of the payment comes into question. Dividend cover below one means the payment is not covered by earnings and the company is using most, if not all, of its profits to fund its dividend payments.

The current dividend cover for the FTSE 100 stands at about 1.7x. A number of companies, for example Vodafone, have dividends uncovered by earnings – and many other have coverage that is particularly low. However, management at Vodafone has attempted to ease fears that its payment isn’t secure. Management also recently announced a major cost cutting programme to help reassure investors about the dividend.

Perhaps the biggest problem for UK income investors is that payments are concentrated in a limited number of companies. The top ten dividend payers account for almost half of FTSE 350 dividend payments, with the top twenty responsible for roughly two thirds. The UK has twice the dividend concentration of US and European equities. This means something going wrong at one business could result in income payments falling substantially. We saw such an unpredictable event in the wake of BP’s disastrous oil spill in the Gulf of Mexico in 2010. The largest dividend payers also tend to have higher dividend yields, so these stocks can form a large proportion of income-orientated portfolios. This lack of diversification increases risk.

Investors should therefore consider buying into some foreign income streams – which is easily achievable through some major funds. Of course, there is the added issue with currency moves impacting the sterling value of these payments – but the same is also true of the FTSE 100. Only around a quarter of the earnings in the FTSE 100 are generated in the UK. This means that blue chip earnings and dividends may be vulnerable to a substantial and unexpected jump in the pound. This is unlikely to happen soon, but some in the market think a rally could happen next year should the UK’s withdrawal from the European Union go relatively smoothly.

So, where in the world are dividends growing rapidly? Dividend payments broke third-quarter records in the US, Canada, Taiwan and India. Banks made the largest contribution to US dividend growth and only one American company in 70 cut its payment. The third-quarter is usually a seasonal low for dividends in Europe, but almost 90% of European businesses increased their payouts.

For those keen on UK equities with a higher–than-average yield, it’s best to focus on companies that have experienced reasonable and steady earnings growth over the last 3-5 years and have a generous amount of interest cover to cushion against the effects of rising interest rates – and therefore debt payments. It is also important that they have demonstrated that they can convert accounting-based earnings into physical cash because, as we are acutely aware in a post-Carillion world, profits are a matter of opinion but cash is matter of fact.

A version of this article appeared in Friday’s Daily Telegraph.

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