Look abroad for income

868-oil-rig-634 — It's not a bright outlook for dividends from Shell and BP

Dividends are a key component of long-term stock returns. While we all get fired up about double-digit capital gains and "multi-baggers", over time by far the lion's share of returns from the equity market come from regular reinvestment of dividends. And at a time of near-zero interest rates, the relatively high dividend yield just over 4% available on UK stocks (as judged by the FTSE 100 index) looks particularly tempting.

One way to measure the sustainability of a dividend payout is to look at the dividend cover. You can calculate this by comparing the company's earnings to the dividend paid out (in other words, earnings per share divided by the dividend per share).

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Obviously, if a company is paying out more in dividends than it's making in profits (the ratio is below one), then that's unsustainable in the long term. Either profits need to go up soon or the dividend will have to go. And ideally, you'd want dividend cover to be significantly higher than one to be safe the higher the better.

So here's a worrying point for UK income investors based on full-year results for 2016, dividend cover on the FTSE 100 is now below one. In other words, in aggregate, companies are paying more cash out than they can cover from their earnings.

This isn't a normal state of affairs. Dividend cover is now lower than it was in the aftermath of the financial crisis, says Economic Perspectives, a consultancy, based on data from stockbroker The Share Centre. Cover peaked at around 2.5 in 2011, and has been falling fairly consistently since.

This is partly down to the troubles of the resources sector. Both BP and Shell the UK's largest dividend payers were hit hard by the 2014 crash in oil prices. While the price has rallied, it's a long way off the $100-a-barrel seen between 2011 and 2013.

Dividend cover for the oil stocks is set to be below one for 2017, according to data from stockbroker AJ Bell. The mining majors have had a rough time too. Commodity prices are recovering now, which will feed into higher profits and improving dividend cover, but in sum payouts for the market as a whole are worryingly reliant on an ongoing recovery in raw-material prices.

In short, if you need income then it's important to diversify. Don't just rely on the FTSE 100, but look for options around the world. Even Japanese stocks, which were traditionally low yielding, are now paying rising dividends.