Vodafone dividend cut highlights need for new approach to income investing

The telecoms companys dividend cut ended a two-decade run of rising payouts. Chris McVey suggests three key issues for equity income investors to consider.

As you may have read last month, Vodafone announced that it was cutting its dividend, despite the board having recommitted to it six months earlier.

Vodafone’s cut ends a two-decade run of rising payouts. It also highlights three important issues that equity income investors need to keep in mind.

The good news is that investors can mitigate this risk by diversifying the types of income funds they hold, and being aware of three key issues.

1) High dividend yields can mean low dividend cover

If you hold a stock for its dividend, you want to be confident that the company can keep paying it. Ideally you want to see dividend cover of 2.0 or above, which means profits are enough to cover the payout twice over.

In the case of Vodafone, dividend cover was less than 1.0 just before the announcement of its dividend cut. This is clearly unsustainable over the long term, so we shouldn’t be too surprised that Vodafone acted as it did.

What it should draw our attention to is the fact that among the big dividend payers, the average dividend cover is significantly below that 2.0 mark. If we look at the 10 FTSE 100 companies that pay the most money out to shareholders, their average dividend cover is less than 1.5.

If we look at the top 10 FTSE 100 companies by dividend yield, the figure is just 1.2.

2) Popular income stocks can have below-average dividend growth

Many of the big blue-chip dividend payers have reached a stage in their maturity where earnings and dividend growth have slowed.

If we take the top 10 companies by total dividend payout and strip out BP and Royal Dutch Shell (because oil price moves make their earnings more volatile), we see that on average their earnings and dividends are expected to grow more slowly than the FTSE All-Share average over the period from the end of 2017 up until 2020.

3) Concentration risk

In the run-up to its dividend cut, Vodafone was one of the FTSE 100’s top 10 dividend payers, by both dividend yield and by the total amount that it paid to shareholders.

In fact, the top 10 biggest dividend payers accounted for more than half the dividends paid by FTSE 100 companies in 2018.

Now consider the fact that three-quarters of traditional income funds hold those stocks, and you’ll see why equity income investors need to have an eye on concentration risk. They may want to consider adding a different type of fund to their portfolio for diversification.

A different approach

It would be complacent to assume that Vodafone will turn out to be an isolated case. So where can income investors find diversification?

Last December, we launched the FP Octopus UK Multi Cap Income Fund, which invests in companies across the entire market cap spectrum, drawing on our longstanding smaller companies’ expertise.

This approach has allowed us to seek out companies with sustainable dividends, which have above-average earnings and dividends growth, and that tend not to appear among the holdings of more traditional equity income funds.

The experience of Vodafone shows that while a household name and impressive past performance may feel comforting, investors need to consider diversification, particularly if income is important.   

Chris McVey is a senior fund manager and head of the FP Octopus UK Multi Cap Income Fund, Octopus Investments.

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