We are living in a very uncertain climate. For the UK dividends market this uncertainty is even more pronounced. If Britain’s armies of income-desperate investors are to be made happy then companies will need to continue to increase their payouts, despite the fact that their own earnings are decreasing. Whilst this may satisfy some customers, this action will clearly have a knock on effect on stocks and shares.
So how can you keep you dividends safe?
There are four key tests for shares, says Russ Mould of AJ Bell, the low-cost investment platform. The first is earnings cover. He says: “Anything below two times the dividend needs watching; a ratio under one suggests danger.”
Second is operating free cash-flow cover. This looks at the cash that funds the dividend and is expressed as the amount of operating free cash flow divided by the total cash value of the dividend paid. The higher the ratio, the safer the dividend because there should be plenty of free cash flow to pay it.
Third is the amount of net cash or net debt on the balance sheet. If there is net debt then this could mean the dividend payout is in jeopardy, because a heavily indebted company will have to pay interest on its borrowings and eventually repay the sum lent.
Fourth is interest cover. This shows how many times annual interest payments are covered by the company’s income. Mr Mould says: “A score above two shows that the company has a margin of safety. In contrast, a plunge towards one could force the company to choose between maintaining the dividend, investing in its core operations or paying its bills, a decision where the shareholder payout is likely to be first for the chop.” A study of the ten highest-yielding stocks in the FTSE 350 index shows that BP and Royal Dutch Shell score poorly on earnings cover, with figures of 0.91 and 0.96 respectively. Mr Mould thinks they should have enough room for manoeuvre to tide them through the next couple of years, although a further sudden fall in the oil price could put them under pressure.
Another high-yielding stock, which AJ Bell identifies as flashing some warning signs, is Carillion, the construction company. It has a lot of net debt on its balance sheet, relative to its size. However, its payout may be safer than it looks because it is almost twice covered by earnings.
One way to secure protection from the pain of dividend cuts is to buy an income investment trust. Since investment trusts are collective funds, which buy a portfolio of stocks, dividend cuts in some shares can be balanced by increasing payouts from others.
According to Alex Paget of Kepler Partners, the investment adviser, investment trusts are well suited to weathering a storm because they are allowed to retain up to 15 per cent of their income each year, so cash held back in good years can be used to boost payouts in lean years.
Some trusts have dividend cover of well above one, led by Chelverton Small Companies Dividend, with a dividend covered 1.77 times by income, Shires Income (1.44 times) and JP Morgan Claverhouse (1.22).
This is far from the only yardstick you should employ when looking for a good income fund. Mr Paget says that, above all, investors should not be seduced into picking the fund with the highest yield, but should look for funds that can grow their payouts over many years. Also they should not neglect capital growth, and look for funds that grow in value, even after paying bigger dividends. Other things to check are the volatility of the fund and the impact of charges on investment performance.
Kepler has combined all this into a system of ratings for income trusts and has published its list of the top five: Perpetual Income & Growth, Edinburgh, Schroder Income Growth, Chelverton Small Companies Dividend and Diverse Income.
Brian Dennehy of Fundexpert, the investment research website, employs a similar approach to sort out which income funds are the most consistent. Troy Trojan income has increased its payout every year for ten years, while Blackrock UK Income managed nine years of dividend growth. JO Hambro UK Equity Income had the biggest rise in payout growth at 173.7 per cent.
Fundexpert also looked at the funds that were best able to combine income and capital growth to produce a good overall return. The winner was Unicorn UK Income, with a total return of 181.6 per cent over the past ten years, followed by Troy Trojan Income, with 123.6 per cent and Royal London UK Equity Income, on 120.4 per cent.
If you need more advice on how to protect your own dividends there are many experts who specialise in the subject that may be able to help and give you suggestions. Consider contacting Alex Paget of Kepler Partners for his personal recommendations. You may also benefit from reading articles on this subject from Brian Dennehy of FundExpert.