Are your dividend payments at risk?

Vodafone cut its dividend payment by 40% earlier this month. How can you avoid similar disappointments?

948-Vodafone-634

Vodafone has recently slashed its payout

In November last year, telecoms group Vodafone said that it would maintain its dividend for the financial year. Chief executive Nick Read faced down market scepticism, saying that he was cutting costs and looking at selling phone masts to raise funds. The market wasn't convinced. Until last week, Vodafone was trading on a dividend yield (dividend per share as a percentage of the share price) of around 9%. That's when it succumbed to the inevitable it slashed ("rebased", in corporate speak) its payout by 40%, as the cost of investing in next-generation technology (5G) continued to climb.

It's not the only FTSE 100 stock whose dividend is at risk (see below). So is there any way to shield yourself from dividend disappointment? One obvious figure to look at before you consider buying any stock on the basis of its dividend yield is dividend cover. You simply divide earnings per share (EPS) by dividend per share. A dividend cover of below one shows that the company's earnings don't cover its dividend payout, and suggest that the dividend is therefore on borrowed time. Vodafone, for example, had dividend cover of 0.9. Ideally, cover would be above two, although this is rare at the moment.

You can also go deeper with this analysis by considering where the money to pay the dividend is coming from. For example, 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? Cover is a basic measure and doesn't work uniformly. But it's a starting point.

Another useful warning flag is the dividend yield itself. The clearest indicator that Vodafone was heading for a cut was its extraordinarily high yield of more than 9%. If a blue-chip share yields 9% at a time when a bank account offers you maybe a bit over 1% if you're lucky, that tells you that investors don't believe it will be paid.

Looking at dividend cover and yield won't, of course, protect you from unexpected events. Any company involved in resource exploration, for example, can be hit by natural or operational disasters. Any company operating in the drugs business might be storing up a future liability in the form of side effects that only become apparent over the long term.

As a result, the boring truth is that there's only one near-certain way to protect yourself from dividend cuts, and that's to diversify. You need to own a range of stocks across a range of industries so that if one cuts its dividend, your income isn't entirely ruined. And while the FTSE 100 is on an attractive yield right now, much of this is being provided by a handful of companies so it also makes sense to diversify internationally. We look at some options below.

How to secure your dividend payout

Meanwhile, Vodafone's fellow telecoms group BT is also under scrutiny its dividend has been maintained for now, and as a result it yields more than 7%. But its plans to build its 5G network will be expensive, and as Phil Oakley notes in Investors Chronicle, its dividend payout is almost entirely uncovered by free cash flow, meaning that it "had to borrow $1.4bn to pay its dividend", which cannot be sustained in the long run.

So what are the best options for diversifying your dividends? You could build a portfolioof high-yielding stocks: by picking 16 to 20 from different industries, you can diversify away the majority of individual stock risk, and insulate yourself from individual nasty surprises, such as the Vodafone cut.

If you don't fancy building your own income portfolio, another option is to invest in an income-focused investment trust. Trusts have the facility to smooth out dividend payments over time by storing reserves in good times and paying them out in harder times. Trusts that are UK-focused with dividend reserves covering more than a year's worth of payouts include Dunedin Income Growth (LSE: DIG), which yields nearly 5% and trades at a discount of nearly 10% to net asset value (NAV), and whose top holdings include Prudential and Unilever; and Merchants Trust (LSE: MRCH), which yields 5%, trades at a slight premium, and holds big names such as BP and GlaxoSmithKline.

For more global exposure, look at Murray International (LSE: MYI), which trades at a small premium to NAV, yields more than 5%, and invests in a wide spread of equities from around the world.

Recommended

Scottish Mortgage Investment Trust update: share price down as tech stocks crash
Investment trusts

Scottish Mortgage Investment Trust update: share price down as tech stocks crash

Scottish Mortgage Investment Trust has been remarkably successful over the years but is now trading at a discount to its NAV due to falling tech stock…
28 Jan 2022
Are recession fears justified? Maybe it’s time to look on the bright side
Economy

Are recession fears justified? Maybe it’s time to look on the bright side

There's a lot to feel nervous about right now, and many people are worrying about an impending recession. But it's by no means certain, says John Step…
28 Jan 2022
Making money is about to get much harder
Investment strategy

Making money is about to get much harder

Soaring inflation, geopolitical risk, bubbly stockmarkets - getting a return on your investment is going to get much more difficult – but not impossib…
28 Jan 2022
How to invest in the chipmakers fixing the semiconductor shortage
Share tips

How to invest in the chipmakers fixing the semiconductor shortage

Last year’s chip crunch brought home how dependent the world is on these tiny pieces of silicon. Chipmakers are rushing to build new factories. Will t…
28 Jan 2022

Most Popular

Shareholder capitalism: why we must return power to listed companies’ ultimate owners
Investment strategy

Shareholder capitalism: why we must return power to listed companies’ ultimate owners

Under our system of shareholder capitalism it's not fund managers, it‘s the individual investors – the company's ultimate owners – who should be telli…
24 Jan 2022
Amazon halts plans to ban UK Visa credit card payments
Personal finance

Amazon halts plans to ban UK Visa credit card payments

Amazon has said that it is to shelve its proposed ban on UK customers making payments with Visa credit cards.
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022