We examine why yields are so high and how to check for income sustainability
Thursday 23 May 2019 Author: Ian Conway

Approximately one quarter of the FTSE 100 is yielding 6% or more, according to analyst forecasts collated by SharePad.

This seems unusually high and begs the question: are UK stocks simply very cheap or are investors pricing in very bad news for many of the biggest companies? 

In last week’s Editor’s View column we asked why income investors had fallen out of love with a large number of UK stocks trading on high yields.

Given the current global environment of low interest rates and low real returns, the lack of interest in big dividend-paying companies is particularly curious.

In the past, investors would have happily mopped up stocks yielding 6% or more, effectively putting a ‘floor’ under valuations, yet in today’s market it’s not uncommon for leading stocks to trade on 8%, 9% or even 10% yields.

One reason may be that these companies come with stock-specific risks which are putting investors off. Another theory is there is more demand for companies which are increasing their earnings and dividends at a decent pace although their current yields are in line with or below the market average.

MARKET IS YIELDING 4.7%

According to AJ Bell Youinvest’s latest Dividend Dashboard study, which takes analysts’ forecasts for regular dividends for all the FTSE 100 companies, the prospective yield on the UK stock market is 4.7% for this year.

Compared with top savings rates of 1.5% on easy-access accounts at high street and online banks, and a yield of just 1.06% on 10-year UK government bonds (Gilts), a 4.7% yield on the FTSE ought to look attractive to income investors.

Historically, a yield of 4.7% is towards the upper end of the market’s range: the only time that the yield has been higher in the past 20 years was during the 2008 financial crisis.

Allianz Global Investors’ head of UK equities Simon Gergel says compared with other global stock markets the yield on the FTSE 100 is the most attractive it has been since 2000.

FAT TAIL OF HIGH-YIELDING STOCKS

Gergel, who with Matt Tillett co-manages the 130 year-old Merchants Trust (MRCH) investment fund, believes the market has become polarised with too many investors over-paying for what are perceived to be quality, defensive growth companies with below-average yields.

That has left a large swathe of good companies with rising earnings and dividends, as well as attractive yields, looking very cheap by comparison.

As an exercise we screened the FTSE 100 index to look for stocks yielding 6%, or 25% more than the current market average.

What we found was a surprisingly large number of well-known, well-run companies which in many cases are yielding significantly more than the market average.

This ‘fat tail’, as it is known in statistics, includes some of the biggest stocks in the FTSE by market value and some of the biggest dividend payers in absolute terms.

In fact, of the 10 biggest dividend contributors to the FTSE overall, four stocks are yielding more 6% while another three are yielding just under 6%.

Despite recently cutting its dividend by 40%, mobile operator Vodafone (VOD) still scrapes into the top 10 in terms of contribution to total dividends although its share price has been very weak in the past few years, much to the frustration of its shareholders.

HIGH PROPORTION OF FINANCIAL STOCKS

We found that 23 out of the 100 stocks in the index have dividend yields of 6% or more, with the biggest concentration in financial firms. Along with financials, there are smaller clusters of miners, utilities and telecom operators, housebuilders, media and tobacco companies.

It’s worth noting that at the other end of the spectrum there are two stocks which pay no dividends at all: fast-food delivery firm Just Eat (JE.) and online grocer Ocado (OCDO).

Within financial stocks, two of the top yielders are high street banks HSBC (HSBA) and Royal Bank of Scotland (RBS) while the other six are insurers.

WHY IS THE MARKET SO SCEPTICAL?

When stocks are trading on high single-digit or low double-digit yields it is normally a sign that the market thinks either the company isn’t going to meet its profit forecasts, or it doesn’t physically have the cash to pay the dividend, and therefore the yield isn’t sustainable.

That was clearly the case at outsourcers Carillion and Interserve, which were both yielding well over 10% on paper before they failed, and at Vodafone before it slashed its payout in order to fund its 5G investment programme.

However, when stocks such as miner BHP (BHP), cigarette maker Imperial Brands (IMB) and housebuilder Persimmon (PSN) are yielding upwards of 9%, we have to ask how much bad news the market is pricing in and whether or not it is being rational.

There are four quick checks we can do to tell whether the dividend is safe, at least in theory:

– Are dividends covered by earnings?

– Are dividends covered by cash flow?

– How much are interest payments covered?

– How big is the pension deficit?

The first two are straightforward and use the profit and loss and cash flow statements. The second two are less straightforward and involve looking at the balance sheet but interest costs and pension deficits are higher up the list of priorities than dividends when a company comes to divvying up its cash.

The question of the pension scheme is particularly relevant because, after the scandal involving BHS, financial regulators have become much less tolerant of companies paying out large dividends while they still have big deficits.


THREE STOCKS TO BUY FOR HIGH YIELDS

Out of the 23 stocks yielding 6% or more, three seem to us worthy of buying at the current price: in the financial sector, Aviva (AV.) and Standard Life Aberdeen (SLA), and in the consumer sector Imperial Brands (IMB).

AVIVA – 7.7% YIELD

Aviva’s (AV.) forecast dividend for this year of 32.2p puts the shares on a prospective yield of 7.7% and it passes the first two tests with flying colours. The payout is covered almost twice by earnings and more than four times by cash flow.

Moreover it has no debt and, fittingly for the biggest corporate pension provider in the UK, the 2018 report and accounts show that it has a pension surplus of £3.25bn, not a deficit. This article provides more detail on why we like Aviva as an investment. 

STANDARD LIFE ABERDEEN – 8.5% yield

Standard Life Aberdeen’s (SLA) forecast dividend for this year is 22.1p, putting the shares on a prospective yield of 8.5%. While this isn’t fully covered by earnings or cash flow, at the end of last year the company had £1.3bn of cash and liquid resources and £1.6bn of distributable reserves against a dividend payout of just £345m so there is more than enough cover.

It’s also worth pointing out that the firm is buying back shares, which increases the total shareholder return. According to the annual report the equity value of its stakes in quoted companies Phoenix (PHNX), HDFC Asset Management and HDFC Life was roughly £4.5bn as of March this year. That compares with a current market value of £6.5bn for the whole group.

Like Aviva it has no debt and its pension scheme is in surplus to the tune of £1.1bn.

Historically we’ve been negative on Standard Life Aberdeen’s investment case, voicing concerns about outflows from its funds and tough competition from lower-cost funds.

However, the shares do look compelling on a sum-of-the-parts basis. Stockbroker Numis sees future catalysts for the stock as being further disposals of non-operating assets, the ongoing efficient efforts, greater focus on the growing and potentially high value platform business and possible long-term operating business recovery.

IMPERIAL BRANDS – 9.6% yield

Imperial Brands (IMB) is a more risky proposition. Although its forecast 205p dividend and 9.6% prospective yield are just about covered by earnings and cash flow, it has a considerable amount of debt which needs servicing.

It also had a pension fund deficit of £463m at the end of last year, which was a £250m improvement on the previous year but still represents a risk.

Against this, it had £775m of cash and liquid resources on its balance sheet at the end of last year although £220m of this was in countries where prior approval is required to transfer the funds abroad.

Being a tobacco producer, it must be said that there is also considerable risk of litigation. So far the company hasn’t had a successful claim against it but if a case were to succeed it might result in a significant liability for damages and might lead to further claims against the business, says Imperial. It adds: ‘Regardless of the outcome, the costs of defending such claims can be substantial and may not be fully recoverable.’

Therefore a 9.6% yield may say less about the company’s short-term earnings prospects and more about its long-term liabilities, meaning investors should decide for themselves whether Imperial fits their personal appetite for risk.


TWO HIGH-YIELDING STOCKS TO AVOID

DIRECT LINE – 9.1% yield

Insurer Direct Line (DLG) is yielding 9.1%, generous because it also assumes it pays a special dividend.

As it stands the payout is barely covered by earnings and is uncovered by cash flow, so in the event that the business takes a hit from higher claims, higher costs or regulatory intervention the first thing to be cut will be the dividend.

By way of illustration, last year the ‘Beast from the East’ pushed up property claims sharply, leading to a drop in operating profits and leaving the 2018 dividend of 29.3p significantly down on 2017’s payout of 35.4p, due to a less generous special dividend.

It has no debt, the pension scheme is £17m in surplus and at the end of last year it had £236m of short-term deposits, plus in the last two years it has released £840m of reserves set aside for claims so there is scope to stick to the dividend forecast. However for our money there are safer FTSE dividends out there.

SSE – 8.8% yield

The second stock to avoid is SSE (SSE) where the forecast 97.5p dividend is nowhere near being covered by earnings or cash flow.

The prospective yield of 8.8% is saying to us that the market thinks the payout is likely to be cut.

As is typical for a utility it has a large amount of debt so interest costs eat up a big chunk of profits before dividends can be paid. The results for the year to 31 March have yet to be released but in the previous year’s accounts net finance costs amounted to nearly 30% of operating profit.

The pension scheme was in surplus by £174m and the firm had £232m of cash on the balance sheet a year ago. The energy price cap and a tough competitive market are expected to have cut last year’s revenues by 5% and operating profits by up to 40% according to the analyst consensus forecast compiled by Refinitiv.

That gives SSE very little room to manoeuvre, and the final nail for us is the spectre of a Labour-led government set on nationalising the energy distribution sector at the expense of shareholders.

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