Dividend Dilemma: Homework is more important than ever

The hunt for yield is littered with banana skins, so income investors must tread carefully. Here's how.

Shareholders of Vodafone (LSE:VOD) are among the most recent casualties of dividend cuts in the FTSE 100, after a (mostly) inflation beating 20 years of annual dividend increases. 

Contrastingly, the majority of dividends are flourishing as payments hit a record high for the first three months of 2019. The amount paid by UK companies rose to £19.7 billion which represents a year-on-year increase of 15.7%, according to a Dividend Monitor report from Link Asset Services.

Yet with yields riding high, the need to do your homework is arguably greater than ever, as Marks & Spencer (LSE:MKS) dividend cut in February also highlights.

Regularity of dividends

Last year, 11 FTSE 100 companies paid quarterly dividends, and recently Lloyds announced that it would be climbing aboard the quarterly dividend wagon too. It joins Shell (LSE:RDSB), HSBC (LSE:HSBA), Unilever (LSE:ULVR), BP (LSE:BP.), GlaxoSmithKline (LSE:GSK), British American Tobacco (LSE:BATS), Carnival (LSE:CCL), Imperial Brands (LSE:IMB), EVRAZ (LSE:EVR), Land Securities (LSE:LAND) and British Land (LSE:BLND), who all pay a quarterly dividend. 

For fund and investment trust fans, investors have an even greater luxury of choice when it comes to generating a regular income.

Whilst quarterly dividends have become a popular feature in the investment trust sector, many more funds by number pay a quarterly dividend, by virtue of there being more of them.

Some 553 funds, according to interactive investor analysis using Morningstar, pay a quarterly dividend, as do 135 trusts based on AIC research – so there is a huge amount of choice. In addition, 147 funds pay a monthly dividend, as well as 7 investment trusts.

Rebecca O'Keeffe, Head of Investment, interactive investor says: "There is no doubt that monthly or quarterly income options can play a great role in trying to generate a regular income – which is especially important for investors who are managing their own income in pensions drawdown. 

"However, despite the vast range of income options available, investors need to be very careful in selecting stocks or even funds based on dividends alone. You must never lose sight of the fact that you want to maximize your total return, and not simply the dividend yield.  Don't forget that most of the big tech companies pay little or no dividends while they are growing rapidly, preferring instead to reinvest their cash directly into the business at very attractive internal rates of return."

interactive investor sheds some light on warning signs that investors should look out for to help spot problems in advance.

Beware a high dividend yield

Rebecca O'Keeffe says: "A high dividend paying stock may be a good investment, but it is equally likely that a high dividend yield could be a warning sign that all is not well with the business.  In many cases, the market may be expecting the dividend to fall.  This could be because cash generated by the business is insufficient to pay the dividend in full, or there may be other significant challenges that the business faces in maintaining such a generous dividend well into the future."

Richard Hunter, Head of Markets at interactive investor says: "There's an old saying that if something looks too good to be true, it probably is. Whilst the FTSE 100 is an attractive hunting ground for dividend seekers, it's worth bearing this in mind. Share prices and yields often have an inverse relationship, so a high yield can actually be a sign that a stock is out of favour. So take a look at the dividend track record – whilst it's no guide to the future, tread cautiously if a company has a high headline yield but a patchy dividend track record."

Nothing is guaranteed

Lee Wild, Head of Equity Strategy at interactive investor, says, "Last November, Nick Read pledged to maintain Vodafone's payout yet dividends were cut this year. Remember that few things in life are guaranteed – so do your homework.

"One of the most useful yardsticks comes from a company's accounts and is the 'return on capital employed' (ROCE). Described by Warren Buffett as 'the primary test for managerial economic performance', it is a good starting point because it factors in debt and other liabilities. Terry Smith, manager of interactive investor Super 60 rated Fundsmith Equity, looks for a ROCE of more than 15%. It is calculated by looking at the profit figure, divided by the assets of the businesses." 

Dividend cover

Rebecca O'Keeffe, Head of Investment at interactive investor says:

"When it comes to yield, it's important to look under the bonnet to help assess whether a company can deliver what it says on the tin and is not overstretching itself - which cannot only compromise shareholder dividends, but compromise long term growth prospects, too - double trouble for investors. 

"Dividend cover is an important bellwether to help gauge whether a company looks able to distribute dividends. Dividend cover is the ratio of a company's net profits to the amount of dividend it pays to shareholders. A dividend cover of 2 times or more is positive for investors and means the company has plenty of leeway to pay dividends. When the dividend cover falls to close to 1, this is a warning sign and investors may not get what they're expecting."