Not all dividends are created equal – Investors must consider sustainability and growth
You do not need The Value Perspective to tell you there are plenty of good reasons to love a dividend – not least how, if you are realistically targeting a return of 7% or 8% a year from the market, the 4% or 5% you can obtain from dividends will take you more than halfway there. It is, however, worth working through a few reasons why not all dividends are created equal.
For starters, just because two different companies each yield 5%, it does not mean they have the same valuation. The key consideration for income-seekers here is how much of any company’s cash is being paid out as dividends – for example, 5%-yielding company a that has its dividend covered twice by cash flows is a very different prospect from company b whose 5% dividend is covered just once.
Consider the free cash being used in each instance to pay out that 5% dividend. Company A has a 10% free cash flow yield – with half of that going out as the 5% dividend – while company B only has a 5% free cash flow yield. If you look at it in terms of how much cash is being generated for shareholders therefore, one company is actually valued completely differently to the other.
That illustration would suggest company B is ‘over-distributing’ and examples of where this might be happening in current markets would include some of the big dividend-payers in the tobacco sector. In contrast, a sector such as pharmaceuticals contains businesses paying dividends that are almost as large but which are also twice covered by existing cash flows.
Sometimes dividends can be an excellent flag of value, but investors do need to dig a little deeper – and, while they are doing so, another important consideration is a company’s ability to grow its dividend. A business that yields a chunky 7% on day one is all very well but could there be a chance that dividend will be the same number in five years’ time? Maybe the company is paying out as much as it is able.
Take the utilities sector, where investors can find companies that pay sizeable dividends but have also taken on a substantial amount of debt. This means, when it comes to using cash flow to increase dividends, shareholders are going to face competition from the debt-holders who will also want to be paid. This conflict can, eventually, prove a significant constraint on dividend growth.
As a contrast, in the financial sector dividends are currently very low following the dividend cuts that took place during the onset of the financial crisis. Starting from a low base, financials should have the ability to grow pay-outs in coming years. It all depends on your appetite for equity market risk but the increasingly short-term perspective of investors means the importance of dividend growth is sometimes underestimated. In our view portfolio diversification should be as integral to the hunt for income as it is for growth.
Such considerations were again underlined by the recent trading statement from FirstGroup, in which it reiterated its aim, first aired a couple of years ago, to grow its dividend annually by 7%. This was well-received by investors at the time and indeed it is a strategy adopted by many businesses as a way of trying to inject confidence into the market.
As investors, however, our job is not simply to take management at their word and mentally bank a dividend they tell us will be 30% higher in four years’ time. Compare FirstGroup, where the dividend is barely covered – if at all – by cash and which has significant amounts of debt, and another business that has stated a similar intention to grow its dividend.
For its part, Vodafone has enormous cash flows. Moreover, not only are these cash flows growing, once the cash being generated by its us business, Verizon, is taken into account, the dividend is roughly twice covered.
It is all very well stating an intention in year one to grow your dividend annually by 7% but that means nothing if you are then going to cut it by 50% in year two or year three. Promises are fine but they are significantly more attractive when they are supported by the numbers in a company’s balance sheet, but of course that still isn’t guaranteed.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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