In November, telecoms giant Vodafone said that it would maintain its dividend at €4.1bn a year (about 12p-13p a share). Chief executive Nick Read faced down market scepticism, saying that the company was cutting costs and might sell its towers.
That saw Vodafone shares trading on a quite extraordinarily high dividend yield of more than 9% at one point late last year (the dividend yield is simply the dividend per share as a percentage of the share price).
What does a 9% yield on a FTSE 100 share tell you? At a time when interest rates are at 0.75%? At a time when a bank account offers you maybe a bit over 1% if you’re lucky? At a time when the yield on a UK ten-year gilt is barely 1%?
It tells you that you almost certainly aren’t going to get paid. It tells you that the odds on that full 15p per share being paid out are in line with the chances of finding Elvis alive and well and living in Swindon – and then having him negotiate a Brexit deal that can find a majority in the House of Commons.
And today, the market’s scepticism has been proved right. Vodafone has cut (“rebased”, in corporate speak, as though we won’t know what that means) its annual dividend by 40%. It’s the first time the company has felt the need to cut its dividend since it first started paying one in 1990.
Scratch one dividend aristocrat.
The biggest red flag for dividend investors
I’m not going to go into the details of Vodafone’s finances – you can get that elsewhere and we’ll have a summary in this week’s issue of MoneyWeek magazine (get your six issues free here).
Instead, I just want to focus on a simple investment lesson that we should all take from this.
If you’re worried about dividend sustainability, there are lots of ways you can check on whether or not the company will pay out. You can look at dividend cover (which gives you an idea of whether forecast profits are going to be big enough to fund the promised dividend payout).
And you can go deeper by considering where the money to pay the dividend is coming from (is cutting costs to pay a dividend really a great idea? If these costs can be cut so readily, then why were they there in the first place?).
But the most obvious, straightforward red flag is that strikingly high yield. For all that we (rightly) mock the idea of the efficient market hypothesis here at MoneyWeek, markets don’t tend to leave £50 notes just lying on the floor – certainly not in an index as closely watched as the FTSE 100.
If a stock is offering a much higher dividend yield than the wider market or its peers, then there’s a reason for that – the reason being that clearly, the market believes it will be cut.
Now, the market can be wrong. There’d be no point in trying to beat it if that wasn’t the case.
But if you are considering investing in a high-yielding stock because you are drawn to the dividend yield, then you must start from the position that you think the market is wrong on the dividend payout.
It’s not high because other investors haven’t noticed and you’ve somehow uncovered a bargain – it’s high because most people think it won’t be paid. And if that’s the case, then you need to explain why.
Why are you right? Why is the market wrong? Write down your reasons. Review them. Do they stand up to scrutiny?
“Vodafone hasn’t cut its dividend since 1990”. That’s “anchoring”. This is a meaningless piece of information. It’s not a good reason to bet on a 9% yield.
“The chief executive said so.” Talk is cheap, as I’m sure some telecoms company once used as a slogan.
“It’s worth a punt.” No. Punting is for horses. You’re an investor.
The honest truth is that if you had tried to make a bull case for Vodafone’s dividend, you’d probably have struggled. And in the cold light of day, that would have made you think twice about putting your money at risk.
So that’s it, one easy lesson – if a stock has an exceptionally high yield, you’d better have an exceptionally strong reason for buying it.
John’s book, The Sceptical Investor, is out now – MoneyWeek readers can get 25% off here.