Amid dividend cuts from Centrica, Vodafone and Royal Mail, Richard Pearson shares five things for income investors to know.
This year has been difficult for those who invest for income, with much-publicised dividend cuts at Vodafone, Royal Mail and Centrica.
The dividend cuts are a timely reminder that investors should always be cautious, particularly when enjoying a high yield.
However, income investors shouldn’t be completely put off by recent cuts; while UK companies may be unloved at the moment, the UK is still one of the highest yielding markets in the world.
For investors wanting to avoid dividend disappointments, here are five things to look out for.
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1) Watch for warning signs
When investing for income, look at the level of dividend cover a company has. This is the amount of profit it makes divided by the dividend it pays; the higher the better as it means it can continue to maintain and grow dividends even when it has a bad year. Companies with a dividend cover of two or above are usually seen as a safer choice.
Investors could also look at companies’ cash flow statements to see how realistic it is for them to maintain payouts. What do they need to pay to service their debt, pay their taxes, top up old pension schemes and how much is left to pay dividends?
Investors should be wary of companies with high dividends that have a low dividend cover. It’s an indication that the stock may be subject to a cut in the near future.
2) Diversify to shelter your income
As ever, a diverse portfolio can soften the blow in the event of dividend disappointments. Diversification is particularly important for income-focused investors as, after a dividend cut investors need to find an alternative source of income but could be forced to sell at a depressed price to get this.
3) Consider certain sectors for long-term dividends
Investors should consider which sector a company operates in. Is the business likely to need expensive capital investment to maintain its relevance or keep up with its competitors? Utilities often offer good yields as they are mature businesses that have fewer growth opportunities to pursue, therefore they return a good portion of their cash flow to shareholders in the form of dividends.
4) Looking for new avenues for income
To make sure that your portfolio isn’t derailed when a company cuts its dividend, investors should consider investing in an income-paying investment trust. The way that investment trusts are structured enables them to have more options to pay out dividends even when times are hard. One way that trusts can maintain a dividend is through dividend cover - holding back up to 15% of their revenue in more profitable years, so they can continue to pay dividends to their customers in more challenging market environments.
5) Too good to be true
In the world of dividends, when you think, “it’s too good to be true”,’ it can turn out to be exactly that. Investors can get caught on the hoof when a company decides to change its policies, but the signs are often there for months before the cut is made.
It is important that investors do their research because it’s often the case that a company’s share price will take a tumble on the announcement of a dividend reduction, which can be a double blow.
Richard Pearson, director at Selftrade from Equiniti.