It cannot be said too often that one of the main reasons the stock market is holding up and the FTSE 100 Index is hovering around the 7,000 mark, is the dividend yield available. Readers of this column would have no difficulty creating a portfolio of stocks to offer an income of 4 per cent or more, relative security and the prospect of a degree of upside, even if that looks limited at this level. This is why income stocks feature so heavily here, be it safe, dull utilities, infrastructure funds or quoted private equity companies.
It is why the dividend yield features prominently on each stock report. Savers will be cruelly aware that there is little income available elsewhere. It is time, then, to spoil the party. How safe is that income?
There are worrying signs that some companies are overstretching themselves in maintaining, and ideally increasing, dividends, with cover, the difference between earnings per share and what is paid to shareholders, becoming worryingly slim. Most companies regard two times earnings as a robust enough cover. Anything below 1.5 times should begin to ring alarm bells. Anything below one means that dividends are being paid out of reserves, a Micawberish situation akin to paying your grocery bills out of a dwindling cash nest egg.
Research earlier this week from AJ Bell, the broker, suggests that slightly more than a quarter of FTSE 100 companies have dividend cover for 2017 of 1.5 times or less, which theoretically puts them in the danger zone. Perhaps more worryingly, of those with the ten highest dividend yields, all but two have cover below that level of 1.5 times. This means they have little leeway to maintain payments should profits suddenly nosedive.
This week Centrica, one of those good income stocks, put out a trading update that suggested the owner of British Gas was in better shape than some had thought. There were concerns the company might have to cut the dividend, after a reduction almost two years ago horrified its legion of private investors. One implication of the update was that the payment was safe. There are a couple of provisos to any concern here. One, that utilities such as National Grid, SSE, the power company, and the two water providers Severn Trent and United Utilities, all of which have cover in the so-called danger zone, have such assured earnings that they can afford to be generous — indeed, that is their main investment criterion.
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Two, that there are often good reasons why companies allow their dividend cover to slip. Three of those ten “generous to a fault” stocks are housebuilders — Taylor Wimpey, Barratt Developments and Persimmon. The builders have had such a run, and have such assured cashflow, that boards have taken the view that cash should be handed back to investors.
Another, Vodafone, will have its dividend barely half-covered. The telecoms provider is just emerging from a heavy investment programme and is now cash positive. Two more are the oil giants, BP and Royal Dutch Shell. Both have indicated that they will maintain payments and the recent recovery in the oil price will help. Some worry about Shell, though.
Others are insurers, whose odd accounting practices do not always reflect the true picture. Admiral, for example, is ostensibly uncovered, but this year’s payment includes a special dividend paid out of reserve releases, cash not needed from previous years.
The last is Pearson, the publisher. There were concerns over this year’s dividend but sterling’s weakness has allowed the company to increase its forecast for earnings, which means there is a small leeway between these and the dividend.
Ben Lofthouse, global equity income fund manager at Henderson Global Investors, suggests that the trick is to diversify. “When you look at the market as a whole in terms of the FTSE 100, the cover is low,” he said. “That’s partly distorted by the oil companies.”
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These will eventually get to a stage when they are paying covered dividends again. UK investors have the benefit of the lower pound, boosting the value of dividends.
All the above suggests that income from the FTSE 100 stocks is safer than it may seem at first. Most of the index has little exposure to the UK economy and whatever Brexit brings. The usual high income stocks will continue to grind the payments out and remain core holdings for retail investors seeking an assured income. This is probably as well, because it is hard to see many other factors justifying share valuations at these levels.