Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Mitchell Fraser-Jones of Woodford Funds explains why investors should be wary of certain dividend stocks, as part of our Guide to Income Investing.
Last year was a year of capital risk. The discrepancy between the best performing stocks on the UK stock market and the worst was very large indeed.
The UK equity market remains volatile in capital terms, but this year will increasingly become one of dividend risk, in our view. Many share prices in 2015 moved to discount the likelihood of dividend cuts, but very few of them have yet materialised. Over the coming months we expect this to change, so income investors will need to tread carefully.
We’ve also done a bit of analysis on the parts of the market that look most susceptible to dividend cuts. We’ve looked at last year’s dividend per share payments from each constituent of the FTSE All Share index, and compared that to each stock’s current year earnings per share forecast, to get a sense of which companies may be over-distributing.
We’ve then calculated a weighted average for each industry based on the current market capitalisation of each stock. A value greater than 100% suggests that last year’s dividends exceed the level of this year’s forecast earnings for that industry as a whole.
On this basis, some stocks in the basic materials, oil & gas and telecommunications industries are potentially over-distributing, with last year’s dividend commitments way in excess of this year’s earnings forecasts. This doesn’t mean that dividend cuts are inevitable this year – dividends are paid out of cash rather than earnings, and the cash flow dynamics of individual firms may be more attractive than earnings.
Furthermore, companies can find cash through other means to service their dividends, such as through asset disposals or the debt market. Nevertheless, we would argue that a reading of above 100% indicates that stocks in these industries are paying unsustainable dividends on the basis of current earnings expectations, and dividend cuts from some stocks are therefore highly likely.
Reassuringly, Woodford Funds portfolios are not exposed to those areas, with the exception of telecommunications, the equity income fund has a position in BT but we are very confident that this business will continue to deliver attractive levels of dividend growth from here.
As such, we remain confident of delivering dividend growth in the year ahead, despite the obvious economic challenges and the prospect of widespread dividend disappointments elsewhere in the market. Indeed, as long term investors, our confidence in the outlook for dividend growth isn’t confined to 2016. The portfolio has been constructed with the aim of delivering consistent and dependable dividend growth for several years to come.
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