How reliable is your income from dividend payouts?

published 4 November 2019

BP oil workers © BP — BP: nice dividend, but is it reliable?

Investors are probably sick of hearing about equity income funds in the wake of the Neil Woodford debacle. But this week attention has turned to traditional equity income funds, rather than Woodford's (which wasn't really an equity income fund at all). The general point (and appeal) of an equity income fund is that it invests in companies that offer higher-than-average dividend yields, whereas Woodford's fund eventually owned large numbers of unlisted stocks paying no dividends at all, propped up by a few mid-cap high-yielders.

Dividend cover is a simple ratio that compares earnings with dividend payouts. Ideally, you'd want to see a dividend cover of twice or more in other words, where earnings are at least twice as large as dividend payouts, providing a nice cushion in case of future disappointments. However, dividend cover across the board has been steadily shrinking and is expected to hit its lowest level in a decade this year. The risk is that this will leave companies unable to maintain their payouts.

Subscribe to 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

As Suter flags up, ten of the highest-yielding stocks in the FTSE 100 have dividend cover of less than 1.5. These include housebuilders Persimmon and Taylor Wimpey and tobacco giant Imperial Brands (all of which trade on extraordinarily high yields of above 11%), while both of the oil majors, BP and Shell (yielding a bit below 7% a piece), are also on the list. In turn, says Suter, of the 83 funds in the UK Equity Income sector, a full 30 of them own five or more of these high-yielding "dangerzone" stocks in their top-ten holdings. Some of the biggest funds on the list include the Man GLG UK Income fund and the M&G Dividend fund.

Does low dividend cover mean a stock is heading for a dividend cut? Not necessarily. Companies with dependable earnings can operate with lower dividend cover than those with volatile earnings. And with dividend yields above 11%, a fund manager may consider a stock worth buying in any case even if the dividend is trimmed, it may still end up being reasonably generous. However, if you are an income investor, look at the funds you own (and any individual stocks you have) to check just how dependent your income is on individual stocks. If your payouts are coming from just a handful of companies, you may want to diversify your portfolio further.

Explore More

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.