The average dividend cover ratio for stocks in the FTSE 350 index has fallen from 1.5x to 1.2x over the past year, according to The Share Centre, prompting concern that UK equity income funds could be heading for a rough ride.
Dividend cover is calculated through a company’s post-tax profit divided by the dividends it pays. The higher the number, the more cash a firm has on hand to pay its dividend and the more sustainable its pay-out is.
However, the average dividend cover ratio across the UK’s largest 350 UK listed stocks is at the lowest it’s been since the third quarter of 2009, when it stood at just 0.7x.
The Share Centre’s research took into account the UK’s 350 largest companies in the year to the end of March 2015, reported by the end of June 2015.
The report found that the drop in dividend cover can be attributed to net profits of some of the UK’s largest firms taking a hit due to global currency headwinds, the plummet in commodity prices and the recent supermarket price war.
Of course, this means that some sectors have suffered more than others, with oil & gas and consumer services companies seeing the largest falls in their dividend cover.
Consumer services companies, which include supermarkets, have seen their dividend cover drop from 1.4x to just 0.6x over the last year, as their net profits plunged by 59 per cent as margins were squeezed.
Supermarket giant Tesco – the largest dividend payer in the sector – cancelled its annual pay-out altogether this year, providing it with a temporary reprieve from other headwinds but still not enough to stop the company underperforming the FTSE 100 year-to-date.
Performance of stock vs index in 2015
Source: FE Analytics
Oil & gas firms’ dividend cover has fallen to 0.7x over the last year on average, with annual net profits lower than a year ago. The UK equity income funds with the largest dependence on oil and gas currently are UBS UK Equity Income at 15.3 per cent, JOHCM UK Equity Income at 13.6 per cent, Allianz UK Equity Income at 12.1 and Scottish Widows HIFML UK High Income at 11.56 per cent.
What is worrying the research team at The Share Centre is that, despite dividend cover being stretched thinner than it has been in years and the aforementioned sectors suffering particularly badly, FTSE 350 dividend payments have risen to £83.1bn, which is an increase of £3.2bn over the last year.
This begs the questions as to whether the attractive dividend yields that some of the larger blue-chips are paying are going to be sustainable for much longer, given that cover ratios are under a significant amount of pressure.
“Dividends are much less volatile than profits,” Helal Miah, research investment analyst from The Share Centre said.
“Shareholders keep up the pressure on managers to sustain annual pay-outs, even in the face of falling profits. With balance sheets flush with cash for the most part, companies will allow dividend cover to fall until it reaches breaking point, particularly if profits are hit by accounting factors such as asset write downs.”
“Eventually, if they don’t anticipate a rapid bounce back in the bottom line, they throw in the towel and cut the dividends. Glencore is a recent case in point. It is crucial investors understand these dynamics at play in sustaining or growing a dividend pay-out before making an investment decision.”
While Miah says many FTSE 100 stocks have stretched their dividend cover by expanding pay-outs despite their margins being squeezed, the analyst adds that the picture is rosier for FTSE 250 companies as they have had less exposure to global trends.
Performance of indices over 1yr
Source: FE Analytics
Not only has the index outperformed both the FTSE Small Cap and FTSE 100 indices over the last year, its dividend cover is significantly higher at 1.5x compared with 1.1x in the FTSE 100. The mid-cap area of the market hasn’t gotten away too lightly though, as its dividend cover has nevertheless decreased from 2.0x a year ago.
Ryan Hughes, fund manager at Apollo Multi Asset Management, said: “Investors do have to be very wary of dividend cover because it’s easy to forget that such a high percentage of income that’s generated from the FTSE 100 comes from very few companies.”
“A lot of that is associated with oil majors such as BP and Shell, and historically the supermarkets would have been a nice yielder, so there are parts of the FTSE 100 that have really suffered on a yield basis, and that does encourage everybody to look for other sources of more sustainable yield.”
“That pushes people down the cap spectrum and into mid- and small-cap for income, which has been a really fertile ground for companies that are cash generative and therefore pay and grow their dividends.”
While Hughes has a limited exposure to an income themes in his portfolios at the moment, he is watching small- and mid-caps are areas of the market closely as a total return strategy.
One fund that he has used historically and believes would be a good investment for income-seeking investors is Marlborough Multi Cap Income, which has been managed by Siddarth Chand Lall since its launch in 2011.
Over this time, the five FE Crown-rated fund has returned 87.57 per cent, more than doubling the return of its average peer in the IA UK Equity Income sector.
Performance of fund vs sector since launch
Source: FE Analytics
“Marlborough is more of a specialist mid- and small-cap house, they’ve got great expertise in that area and they’re able to access some nice-growing businesses that are cash generative,” Hughes continued.
“This is critical when you’re looking at income – you need businesses that have got sustainable yield rather than just a lumpy yield, and they’ve again proven over the years that they can find these types of businesses and deliver some nice returns over the long term.”
Marlborough Multi Cap Income has a clean ongoing charges figure of 0.79 per cent and yields 4.29 per cent.
