Adventurous Investor

September 21, 2012 5:46 pm

Dividend canaries that warn of a cut

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Watch out for warning signs
David Stevenson

Everyone loves dividends. The price of shares may wax and wane but that dependable cheque that drops on to the doormat twice a year is valuable to growth and value investors here and elsewhere.

Globally, equity markets are yielding about 3 per cent – give or take a half per cent either way. The UK market is something of a star performer, with a yield of about 3.7 per cent, about twice the yield on ten-year gilts.

But the London market isn’t the only standout yield generator – Europe is churning out the dividend cheques too. Spain’s Ibex 35 benchmark index, for instance, yields about 6 per cent.

Spanish telecoms group Telefónica accounts for a fairly big chunk of that juicy-looking yield, but it’s just provided a demonstration of the dangers of relying on historic dividend yields. It said in July that it will pause payouts for 2012 and resume from a lower level (the dreaded “rebasing”) in 2013. So while the data pages on FT.com (and many other websites) show that the shares yield 11 per cent, investors will get nothing like that this year.

Many other European companies may be tempted to follow in the wake of Telefónica, and I’d also be worried that UK dividends may be vulnerable, especially as emerging markets and the US start to slow. For income-oriented investors a dividend cut is usually a double blow, with an immediate share price fall, compounded by a lower (or non-existent) yield.

What makes matters much worse is that investors, professional and private, are often much too blasé about the likelihood of a dividend cut. Rob Davies is a dividend-focused fund manager who runs the Munro fund and he’s compared the flow of dividend payments for the FTSE350 index over the past four years with the forecast payout. His numbers suggest that in 2009, as we fell into a recession, analysts overestimated the total dividend payout by a staggering £11bn, although it is worth noting that Davies’s analysis suggests dividends also increase faster than analysts expect in an upturn.

BlackRock’s red flag

BlackRock has looked at another red flag – the absolute level of the yield. According to Stuart Reeve of its global equity income fund, investors should compare that yield against the wider market, with a yield in the top decile (the top 10 per cent of the range of yields in the market), highly suspicious. According to Reeve, shares in the second and third deciles of yielding stocks produced the best risk-adjusted returns. In simple terms, a very high yield “often signifies that a company is distressed and may not actually be able to pay its dividend going forward”. My own experience tends to suggest that a yield above 6 per cent deserves some scrutiny, whereas a yield above 8 per cent would warrant a much closer look at the balance sheet.

Which brings us back to that issue of the balance sheet and debt. Many investors tend to look at something called the dividend cover, which compares earnings per share to dividends per share. In an ideal world we’d be looking for dividend cover of at least 1.5 if not 2. But of course earnings are an accounting creation whereas cash flow is what actually underwrites the cheques. That’s why I also look at the net cash inflow (after capital expenditure and all other cash-based items) with a cover of at least two an ideal threshold.

But how should an investor avoid the trap of being taken in by what looks like a juicy yield, only to find themself the victim of a dividend cut? It’s not always obvious that one is on the way – for instance, Telefónica’s first reduction, announced at the end of 2011, caught the market by surprise.

A recent research paper by analysts at French bank BNP Paribas flagged up a key warning signal – credit default swaps (CDS). These reflect the cost of insuring the debt of big companies against default, expressed as a percentage of the debt amount. BNP’s analysts crunched the numbers to see if a sudden increase in that “insurance premium” was useful as an indicator of future trouble – and their analysis suggests that it is. The probability of a dividend cut increases dramatically once the CDS premium on company debt hits 300 basis points (or 3 per cent in normal money).

Apply that criterion to European equity markets and you have a long list of Italian and Spanish institutions, including banking giants Santander and BBVA as well as Italian utility Enel.

Back here in the UK, their analysis suggest that there is much less risk with no very big companies running CDS spreads above 300 basis points, although personally I’d be keeping a beady eye on the likes of Marks and Spencer, GKN and Anglo American, where CDS rates are quite high. And Anglo has got past form when it comes to dividend cuts.

The BNP Paribas work reminds us that debt is probably much more important in our nervous, risk-averse markets. According to Gervais Williams, who manages a dividend-focused fund managed called the Diverse Income investment trust for MAM, the key is to work out the true level of “gearing”. According to Williams, “debt is the most obvious gearing but with the sophistication of the financial sector investors do need to raise the bonnet of the corporate. Many use invoice factoring [borrowing against debtors’ obligations] and in these cases falls in turnover can cause a critical shortage of cash flow very quickly”.

Yet maybe we shouldn’t be overly gloomy. Remember that analysis which reminded us that most analysts woefully underestimate the upturn in dividends? If the eurozone avoids a depression, I suspect that a focused bet on local dividend payers might be a very profitable strategy.

And experience also reminds us that many companies that do decide to chop their dividends (and cut debts) oddly enough end up becoming better long term investments. A dividend cut often presages changes in the boardroom, with new blood reinvigorating the company and the share price.

adventurous@ft.com

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