High yields can spell trouble, but Stockopedia's Ben Hobson has screened the market for a combination of big payouts and financial stability.
Dividend payouts reached a record £30.7 billion in the second quarter of this year, but it’s not all good news for income investors. One of the biggest challenges faced by those chasing high yield from equities is the risk that a seemingly attractive payout will end up being cut further down the road.
For shareholders in groups like Capita, AA and Inmarsat dividend cuts over the past year have been a sad reality. But while there are no failsafe ways of insuring against payout cuts, there are strategies that do their best to avoid them. One of those is the Quality Income strategy.
There are some interesting trends in the current dividend landscape. Most income investors will know that commodity stocks - particularly mining groups - have been increasing their payouts in recent years. After a very poor period during the last decade, these highly cyclical firms are back to making record-breaking payouts. BHP Billiton was just one example very recently.
Unsurprisingly then, the latest dividend statistics from Link Asset Services show that it was indeed mining stocks, together with insurers, that led the dividend charge during the spring. Mining dividends leapt by 95% year-on-year. Overall yields from UK equities now stand at 3.9%.
Of course, many income investors shoot for better than average when it comes to yield. Yet the risk of buying stocks on exceptionally high yields is that they can be a signal of trouble ahead. High yields are often caused by tumbling share prices, which in turn are triggered by uncertainty in the market about a firm’s outlook. So high yields can end up being a dividend trap.
To avoid this, some studies of equity income strategies suggest it’s worth steering clear of the very highest yields altogether. Instead, it's preferable to mix reasonable yield with high company quality to try and ensure the payout is sustainable. In recent years, this has been a favoured approach by the quant teams at investment banks like Societe Generale and Credit Suisse.
Screening for quality income
The idea behind Quality Income is that financially strong firms are less likely cut their dividend payouts. Typically, it avoids the very highest yields in the market, preferring more modest yields in financially strong firms with low bankruptcy risk.
For the average individual investor, there are a host of possible metrics that can be used to measure financial health. It’s a personal choice, but at Stockopedia we use the following rules:
● A yield of more than four percent (but less than 15%).
● A minimum market cap of £800 million.
● Each firm should pass at least seven of the nine checks in the Piotroski F-Score. The F-Score looks for improving trends in a company’s profitability, debt, liquidity, share dilution and operating efficiency.
● No obvious risk of bankruptcy risk based on another accounting checklist called the Altman Z-Score.
● Financial stocks are excluded.
To get a broader view of each company's quality, we've also included Stockopedia's Quality Rank. This scores and ranks each company against a range of 'quality' measures and brings them together in a single number - the higher the better.
|Name||Mkt Cap £m||Forecast Dividend Yield %||Piotroski F-Score||Quality Rank||Sector|
|Dixons Carphone||1,963||6.5||7||64||Consumer Cyclicals|
|BHP Billiton||85,742||6.1||8||88||Basic Materials|
|Rio Tinto||63,017||5.9||7||88||Basic Materials|
Source: Stockopedia Past performance is not a guide to future performance
The results of this screening approach show just how dividend yields can be influenced by industry cycles.
Housebuilders have seen their share prices come under pressure over the past year because of concerns about a weakening housing market. But those worries haven't fed through to the financials yet, so the falling prices have pushed up yields. As a result, you see groups like Persimmon and Berkeley Group Holdings (The) scoring highly against the quality income rules.
The most noticeable trend, though, is the presence of mining and resources stocks. BHP recently announced a record final dividend as it claimed to have moved on from several dark years. That echoes around other similar groups, with EVRAZ, Rio Tinto, Glencore and Centamin all making this high yield list.
These results show the ongoing challenge that investors face in balancing the appeal of high yield with firms and sectors that maybe facing cyclical headwinds. The advantage of the quality income strategy is that it focuses on individual company strength. The financial resilience of these firms ought to offer some protection from cyclical swings and the risk of dividend cuts. It won't always be the case, but there is evidence that avoiding the very highest yields in favour of owning better quality stocks is a more profitable endeavour.
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