In Extreme medicine, we offered some thoughts on the UK equity income market based on the 14 companies that had issued results on a single day picked at random from the recent results season. Of those, 12 had been able to raise their dividends by anything up to 27%, one had left theirs unchanged and the other stood out like a sore thumb. Insurance giant Aviva had cut its dividend by 44%.
Investors wondering whether any warnings signs of this shock announcement could have been spotted in advance will find one answer in the following chart, which we have often used and which plots the UK’s top 20 dividend-paying stocks – on one axis by yield and on the other by value, through Graham & Dodd price/earnings ratios, which use a 10-year average of a company’s historic earnings.
Between them, these 20 companies account for more than two-thirds of the UK market’s total dividend payouts, which might appear to make them prime candidates for inclusion in most equity income funds. Here on The Value Perspective, however, we prefer to look beyond a business’s current dividend yield and focus on two other aspects.
One, which is where the Graham & Dodd metric comes in, is the value of the business – how cheap is it really? Attractive income investments should come from the intersection of income and value. As such, the companies we like to own are to be found in the top left corner of the above chart.
However, the other aspect, which is equally important, is the sustainability of the dividend – can it grow over time? It is all very well having a high yield today but, if you cannot grow it, inflation is going to erode the value of that income over time. In our view, any income investment needs to be able to grow its dividend at least in line with inflation.
Understanding the sustainability of a dividend is slightly more complex than looking at a chart and involves an in-depth analysis of a company’s balance sheet and likely profit generation. At first glance, the above chart might suggest Aviva was the most attractive company among the ‘mega-income’ payers but this attraction was only superficial. The in-depth work raised significant questions about the resilience of the company’s balance sheet and the risks to the dividend that result.
To be fair, the new management team at Aviva have made some moves towards addressing the business’s problems. They have, for example, made disposals and – in the move that made all the headlines – they also took the tough decision to cut the dividend as a way of preserving capital within the group. That action not only vindicated our position but, more broadly, it highlighted the benefits of fundamental company analysis and truly active investment management.
Furthermore, it serves to underline the importance of thinking about a dividend in a more holistic way – that is to say, to factor in tomorrow’s income as well today’s. Those who do so should give themselves a better chance of steering clear of some of the dividend-cutters that can so put a dent in an income portfolio.
After all, if a company you own cuts its dividend, you not only find a hole in your income, you will probably also suffer from a hole in your capital pot because, as has happened with Aviva, the shares will fall significantly as a consequence. It is impossible to be 100% accurate – The Value Perspective has owned dividend-cutters in the past and no doubt will again – but by at least attempting to avoid them, you should improve performance.
As we pointed out in Hybrid society, an elevated yield suggests heightened risk and would-be investors have to be aware what that is. History indicates the majority of forecast 7%-plus dividends are ultimately not realised and so anybody buying into a company with a yield of that magnitude needs to be very confident of its sustainability. Statistically, anything above 4.5% is ‘buyer beware’.