Dividend health check: High-yield stocks and problem funds

Our experts discuss health checks to assess company dividends and also how spot a walking wounded funds.

The search for yield is becoming ever more difficult for investors.  Thanks to interest rate cuts and ever greater volumes of quantitative easing, central banks have succeeded in pushing large portions of the bond market into negative territory, such that there are now something in excess of $15 trillion of bonds around the world that trade on a negative yield.  Those bonds that do pay a positive yield are unlikely to give you much of a return once inflation has been taken into account.

The good news is that there are still plenty of UK equities that offer very attractive looking dividends.  The problem for investors is identifying those with a sustainable dividend yield, while trying to avoid those that may be about to cut payouts.

Link Group's Dividend Monitor gives investors a snapshot of the current state of UK dividends. In its latest dividend monitor, Link Group paints a mixed picture of the health of UK dividends. 

Whilst the quarter three headline dividend growth rate came in at 6.9%, well ahead of the long-run trend of 5% per annum, this was flattered by high special dividends and the weakness of the pound. Without any special medicine, underlying dividends (which exclude specials dividends) contracted by 0.2%.  Worse than that, on a constant-currency basis, underlying UK dividends fell by almost 3% in the third quarter according to Link Group, the worst quarterly performance for three years.

What tools can yield-hungry investors use to assess the likely health of a company? 

The dividend cover thermometer

Rebecca O'Keeffe, Head of Investment, interactive investor says: "There are a number of health checks you can do to assess company dividends, and dividend cover is an important and quick way to check the temperature, showing the ratio of a company's net profits to the amount of dividend it pays to shareholders. A dividend cover of two times or more is a healthy level for investors and means the company has plenty of leeway to pay dividends. When it falls to close to one, this is a sign that investors may not get what they're expecting."

The full medical

Richard Hunter, Head of Markets, interactive investor, says: "A stock that looks healthy on the outside isn't always what it appears to be. Whilst the FTSE 100 can be an attractive hunting ground for dividend seekers, share prices and yields have an inverse relationship. In other words, a high yield can actually be a warning sign that a stock is out of favour. So, it's important to look at those health records – in the form of the dividend track record. It won't be able to predict future health, but it might make you think carefully - a patchy dividend track record is far from a glowing health check."

Doctor's orders

Lee Wild, Head of Equity Strategy, interactive investor, says: "Dividend cuts can be painful for income seekers, but sometimes it's a case of 'doctor's orders'. Earlier this year, Royal Mail (LSE:RMG) said it will cut its dividend as it injects £1.8 billion into its postal service as part of a five year recovery plan. Marks & Spencer (LSE:MKS), Centrica (LSE:CNA) and Vodafone (LSE:VOD) have all cut their dividends this year; in the case of Vodafone, this came despite CEO Nick Read pledging only last November to maintain Vodafone's payout. Nothing in life is guaranteed, least of all dividends – so it's important to do your homework and build a diversified portfolio.

"There's no better medical report than a company's accounts – if you know how to interpret it. The 'return on capital employed' (ROCE) is the ultimate body mass index for a company as it helps you gauge how much debt is weighing on the company. Described by Warren Buffett as 'the primary test for managerial economic performance', it factors in debt and other liabilities and is calculated by taking the profit figure divided by the total assets of the business.” 

Not all cuts to dividends are bad

O'Keeffe adds: "It is also important to highlight that a cut in dividend is not necessarily a sign of impending doom and gloom. For some companies, a temporary cut to a dividend can actually be a sign of prudent management. The panic that comes with dividend cuts shows that there can be an unhealthy degree of myopia among investors, so it is important to look beyond the headline dividend to better understand the bigger picture.

"The cut to dividend announced by Centrica and Vodafone earlier this year (in May and July respectively) are good examples. The market consensus was that the cuts should have been made years ago as both companies have been paying out more than they could afford in terms of profits/cashflow, but so long as the illusion persisted that the dividend could be maintained, everyone was happy.

"Contrast that with the gold miners. For them, their balance sheet is sacrosanct, so they will only ever pay out as much as they can afford without compromising the long-term health of the business."

Assessing the health of high yielding funds

For investors who want to invest in funds instead of individual shares, are there any tell-tale signs that investors should look out for in assessing whether a fund is limping on, rather than in rude health?

Walking wounded? How to spot a walking wounded fund

O'Keeffe says "Investors have a number of ways to spot a walking wounded fund. The first is to look at the size of the fund. A significant fall in the value of the fund is indicative of either poor performance, large redemptions, or both. This should be the first warning bell.  

"Another issue is long-term underperformance, which can be a catalyst for further problems down the line. As investors start withdrawing money more quickly, this puts enormous pressure on the fund manager to dispose of liquid assets, potentially the better performing ones in the portfolio, making it more difficult to turn things around as the quality of remaining assets deteriorates.

"The key for investors is to keep on top of your investments. One good way to manage your holdings is to traffic light your investments. Green means you are happy that things are going well. Amber means that you need to pay close attention and review it more often. Red means that you have given a fund the chance to turnaround, but it has run out of time and you should sell and buy a better option."

Go global?

Dzmitry Lipski, investment analyst, interactive investor, says: "The greatest wealth is health, but income investors have had to grapple with the multiple ailments of low interest rates, market uncertainty, and steadily falling bond yields – not to mention the cloud of Brexit uncertainty. Whilst we shouldn't ignore the UK, it makes sense to diversify.

"It is a difficult environment for income seekers who don't want to take on excessive levels of risk. Bruce Stout, manager of Murray International (LSE:MYI), a Super 60 rated fund, has tackled this by focussing on capital preservation, as well as capital appreciation, looking at both equities and bonds. Stout looks for value companies with defensive qualities where he has confidence that the companies will be able to continue to deliver earnings and dividends. His aversion to debt heavy 'zombie' companies, kept artificially alive by QE, has often seen him look to emerging markets. This is a high conviction fund that will deviate significantly from the pack, but one that we rate highly.

"Higher up the risk chain is Guinness Asian Equity Income, focussing on high quality dividend‐paying companies in the Asia Pacific region that might have, in the short term, fallen out of favour. High portfolio concentration of around 36 holdings means it is high risk, so better as a satellite holding in a well-diversified portfolio. Contrarian income seekers may also take a look at property and we like BMO Commercial Property Trust (LSE:BCPT). Despite challenging Brexit headwinds for UK property, yields and valuations remain attractive relative to other asset classes, and property remains a sound diversifier for income seeking investors and for diversification purposes – as long as you can take a long term view and ride out those Brexit jitters."