Dividend cover amongst some of the UK’s best-known income stocks has reached worryingly low levels.
Ideally, investors like dividends to be covered by more than two times forecast earnings to feel that a company can comfortably pay out a dividend. However, data from broker AJ Bell shows that dividend cover across almost half of FTSE 100 companies is below this level, with 1.47 representing the average level. For the 10 highest-yielding FTSE 100 stocks, average dividend cover was even lower at 1.22.
This serves as a reminder that investors cannot always rely on FTSE 100 names to deliver the income they need. It also shows that investing for income is as much about avoiding dividend cuts as it is about picking stocks that can successfully grow their dividends over time.
Getting the right balance of stocks that can pay a healthy yield, alongside those with dividend growth potential, is therefore essential. Investors who back the right income stocks can benefit from the compounding effect of reinvesting the returns made on the underlying portfolio. This maximises the potential to boost gains further.
Balancing Risk On Income Portfolios
Before portfolio construction can begin, Richard Whitehall, a portfolio manager at Morningstar Investment Management, suggests setting out your objectives.
“What are you trying to achieve? Do you want to achieve a high income regardless of risk or capital growth? Or are you trying to achieve a realistic and sustainable level of income while keeping the portfolio’s risk characteristics within certain levels?” he explained.
In his opinion, investors must keep an eye on risk, particularly as low interest rates and bond yields have pushed investors to chase yield and, unwittingly or not, to take on more risk.
Getting The Right Mix of Income Stocks Within Your Portfolio
“The way we look at income investing is getting the balance between an attractive dividend today and growth in the future,” said Hugh Yarrow, manager of the Evenlode Income fund.
He looks for stocks that have potential for dividend growth, which also pay out a reasonable starting yield.
In his opinion, investors must be careful not to be tempted by high headline yields and should instead focus on balance sheet strength. This is because some companies have used cheap debt in recent years to fund dividend payments or share buybacks to keep shareholders happy. This could ultimately put pressure on dividends in the long run.
In contrast, AstraZeneca (AZN) and GlaxoSmithKline (GSK) are examples of higher yielders where he feels positive about the long-term prospects. Both are currently restructuring their businesses to compensate for revenue declines that have resulted from drugs coming off patent. Although they are going through a difficult period from an operational perspective, he expects the restructuring will pay off.
Meanwhile, engineering software provider Aveva (AVV) is the lowest yielding stock in the portfolio at 2%, but the fund manager sees potential for dividend growth in the future.
“It is a very high quality business, with a large cash position, no debt and good dividend cover. Its latest dividend increase was 20%, so it is growing quite nicely,” Yarrow said.
Yarrow and Peters aim to insulate the portfolio from a range of economic outcomes by targeting companies with strong balance sheets that can generate high levels of free cash flow. They also like companies with a high proportion of repeat business.
Premium to Pay For ‘Core Compounders’
Carl Stick, manager of the Bronze Rated Rathbone Income fund, places stocks into three categories. Firstly, the ‘core compounders’, which account for 40% of the portfolio. These are businesses with a good track record of paying dividends and investing capital back into the business. He describes Reckitt Benckiser (RB) and Howden Joinery (HWDN) as examples.
“These are high quality businesses that generate decent returns on investment and we believe they will continue to generate returns over many years - but they are expensive and if you own them now they are trading on high earnings multiples and potentially a low yield low as well,” Stick explained.
In his opinion, income investors must balance two key risks. The first is ‘business risk’ associated with the prospects of a company. The second is ‘price risk’, which currently applies to ‘core compounders’. If a stock looks expensive, investors should think about how it will perform if the market falls.
So-called ‘cash cows’ represent the next category, making up 20% of the portfolio. These companies generate high returns but do not typically reinvest in the business because growth prospects are not as strong as they once were. Tobacco, utility and telecom stocks are cited as examples.
Cyclical businesses, including turnaround stories, fall into the fund manager’s third bucket. Oil majors, housebuilders, miners and banks sit in this category, which accounts for 30-35% of the fund. Berkeley Group (BKG) and Halfords (HFD) represent two domestically focused names in this category that Stick increased exposure to over the summer.
Can Income Investors Benefit For Weaker Sterling?
Alex Brandreth, deputy chief investment officer at Brown Shipley, points out that income investors stand to benefit from the one-off positive currency impact from sterling weakness if they have exposure to companies with overseas earnings.
Brown Shipley expects to see inflation increase at the end of this year, following the bottoming of the oil price in February, which could result in companies increasing prices. With economic growth forecast at 1%, he expects that most FTSE 100 companies can grow earnings above this level.
