Avoid Dividend Traps

Dangers of being enticed by high dividend yields in the UK market

Dangers of being enticed by high dividend yields in the UK market

 

For a while now, the UK market in aggregate has tended to pay out a higher proportion of dividends than many of its international counterparts. However, the recent changes to the macro environment brought about by the coronavirus pandemic should prompt investors in the UK market to think more carefully when assessing income opportunities.

AJ Bell publishes a quarterly “Dividend Dashboard” review, which looks specifically at the dividends paid out by FTSE 100 companies. Given the size of these businesses, it is not surprising that companies within the FTSE 100 are responsible for the bulk of dividend payments from UK stocks, so AJ Bell’s dashboard provides a good proxy for the UK market as a whole. In its most recent Dividend Dashboard for Q2 2020 (published on the 19th July 2020), AJ Bell reported that forecast 2020 dividend payments from FTSE 100 companies had fallen by around a third, from £91.1bn at the start of the year to £62.3bn at the time of publication. It seems that, at a time when yield hungry investors need income the most (given the paltry yields available on cash accounts and bonds), they are being let down by the UK market.

Let’s take a look at some of AJ Bell’s data to explore why this could be. By the end of Q2 2020, 48 of the FTSE 100 constituents had cut, deferred or cancelled dividend payments, leaving the index on a forecast yield of 3.6% vs 4.7% at the start of the year. The total value of dividends paid out by the index had shown year on year growth from 2010 to 2018, before an 11% decline in 2019. AJ Bell’s forecast for 2020 represents a further 17% decline over the 2019 level, though this does not take into account the recently announced cut from BP and cancellation from Glencore. Now only 14 of the FTSE 100 constituents can boast the proud record of year on year growth in dividends over the last 10 years (down from 25 at the start of the year).

So, is the worst over yet? It could be but I wouldn’t get too complacent just yet. You see, a particular problem with the UK market is that a high concentration of dividends are paid out by a relatively small number of firms. At the end of Q2 2020, the top 10 FTSE 100 dividend payers accounted for 55% of the total amount that AJ Bell had forecast to be paid out in 2020. Add in the next 10 largest payers and we find that the top 20 payers accounted for 74% of the total forecast payout.

These top 20 payers are shown in the table below:

Top 20 FTSE 100 dividend payers at the time of AJ Bell’s Q2 2020 Dividend Dashboard (AJ Bell, 2020)

Note that, as stated above, this predates the recently announced 50% cut from BP and dividend scrappage from Glencore, which combine to reduce the aggregate payment level by around £4.24bn. Although many of the remaining companies seem to have not too bad levels of dividend cover at present, as the economic disruption wrought by COVID-19 starts to filter though in company results, it wouldn’t be surprising to see coverage levels coming under pressure, making it hard to say with any certainty that we are out of the woods in terms of dividend reductions from the biggest payers yet.

The concentration risk of the UK market to income seeking investors is exacerbated by the fact that many of the large payers operate within sectors that are, at best, slow growth and, at worst, facing structural decline. Looking at the table above, sectors such as Oil and Gas, Tobacco, Utilities, Miners, Consumer Goods and Insurers feature prominently. Hardly sectors that you would naturally seek out for high levels of long term growth and also sectors where if a dividend cut was made, it make take a while for dividends to come back up to prior levels (if, indeed, they ever did get back up to these levels).

Perhaps the expectation of generous dividend yields that has grown up among UK investors over the years hasn’t helped matters much. If up and coming firms feel pressurised to pay out more than they really should to placate investors, this may mean that they retain insufficient cash within their businesses to reinvest for future growth, damaging long term business prospects.

So, what is an income seeking investor to do? Well, rather than seeking out the companies currently paying out the highest dividend yields, it may be better to focus on the companies best placed to grow their dividends over time. This may mean choosing a company whose current dividend yield is very low or even a company that is not currently paying a dividend but is likely to be in a position to pay one in the future. You should be seeking out quality businesses with strong competitive positions, robust cashflows and ample opportunities for business growth. These types of businesses are more likely to retain a higher percentage of their income to capitalise on growth opportunities, so they may not sport the highest yields on the market at the time of purchase. However, for the long term investor, they are likely to be far more rewarding than a slow growing or declining company that just happens to have a high dividend yield at the time of purchase. To emphasize the point – the target for income investors should be long term, sustainable income growth, not short term yield.

By choosing companies able to continually grow their dividends over time, you not only generate a growing income stream for yourself but you also position yourself very well to enjoy strong long term capital growth. For the 14 companies identified by AJ Bell as having managed to sustain 10 years of unbroken dividend growth from 2010 to 2020, the average total return was 621.9%, which compared to an average total return for the FTSE 100 as a whole of 74.9%. Interestingly, only 4 of the 14 were actually members of the FTSE 100 at the start of the 10 year period, illustrating the point that choosing companies with greater prospects for long term growth (ie. not necessarily already very large businesses) trumps just plumping for lumbering giants offering high yields at the time of purchase.

Here at Sterling, while our focus is more on capital growth than income, we recognise the characteristics of quality businesses that can lead to excellent opportunities for income investors (ie. strong competitive positions, robust cashflows and ample growth opportunities) and we readily welcome such businesses into our portfolio. As our key area of focus is the UK small and mid-cap space, we feel that we are well positioned to identify tomorrow’s dividend heroes relatively early on in their development.     

 

 

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