Twice is nice – Unlike books, dividends really should be judged by their cover
As of the end of March 2015, investors could obtain more than twice as much in yield from the FTSE 100 index as from the 10-year UK government bond – 3.53% versus 1.7%. Meanwhile, at yields of 3.36% and 3.33% respectively, the FTSE 350 and FTSE All-Share indices were only just short of being able to make the same claim.
We have risked labouring this comparison between the yields on UK equities and gilts because many investors do use it to form a judgement on the cheapness – or otherwise – of the respective asset classes. As the following chart illustrates, however, when it comes to assessing the yield on offer from the equity market, it pays to think about more than the number next to the percentage sign.
As you can see, the chart divides the constituents of the FTSE 350 into five ‘buckets’, according to the size of their yield – less than 2%, 2% to 3%, 3% to 4%, 4% to 5% and more than 5%. The left-hand bar of each pair shows the number of companies paying the relevant level of dividend while the right-hand bar shows the combined market capitalisation of each bucket.
As you might expect, there are a lot of companies that yield a little, a reasonable number that yield a reasonable amount and a few that yield a lot. However, what really stands out from a first look at the chart is that bar on the far right-hand side, which suggest there must be some very large businesses in among the big dividend-payers.
And indeed there are – in that bucket, to name but three, you will find BHP Billiton, HSBC and Rio Tinto, which between them make up roughly a fifth of the entire market capitalisation of listed UK businesses. Still, while that may be an arresting statistic, it is not the main point of this piece, which is that investors should focus not just on the size of a dividend but also on its sustainability.
Put bluntly, sustainability is all about whether a company can afford to maintain its dividend pay-outs – after all, if a business is paying out more than its entire profits, its dividend will hardly be sustainable. As a rough rule of thumb then, one might reasonably expect a company to pay out half of its profits to shareholders as dividends while retaining the other half, say, to reinvest in the business.
That is known as ‘2x cover’ and, as you can also see from the above chart, the number of companies in the plus-5% bucket that can boast such a ratio is a very round one indeed. In each of the two left-hand buckets, more than three-quarters of the companies have 2x cover but, as dividends edge higher, their level of cover drops off alarmingly.
In total, there are 68 FTSE 350 companies – among them some huge UK businesses and, all together, a fifth of the whole index – that yield more than 4%. Yet just six of them are covered at what, here on The Value Perspective, we would regard as a historically sustainable level. That is not remotely to suggest the rest will be cutting their dividends tomorrow – only that, the next time you read about all the fantastic yield on offer from UK equities, you remember it is not just size that matters.
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 Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
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