Is your in­vest­ment in­come about to be cut?

The Daily Telegraph - Your Money - - YOUR MONEY -

The re­cent tra­vails of div­i­dend-pay­ing stocks such as As­traZeneca and Prov­i­dent Fi­nan­cial have high­lighted the risks that in­come in­vestors are ex­posed to. Both com­pa­nies were very pop­u­lar with in­come seek­ers, but Prov­i­dent Fi­nan­cial has scrapped its in­terim div­i­dend and there are ques­tion marks over As­traZeneca’s abil­ity to main­tain its pay­ments to share­hold­ers.

This comes at a time when “div­i­dend cover”, the de­gree to which com­pa­nies’ prof­its ex­ceed their div­i­dends and there­fore an im­por­tant safety mar­gin, is fall­ing.

“In­vestors or fund man­agers who rely on a hand­ful of stocks to pro­vide an in­come stream are play­ing a dan­ger­ous game,” said Joshua Aus­den, head of client in­vest­ment strat­egy at Nep­tune In­vest­ment Man­age­ment.

“Div­i­dend cover is at its low­est level since the fi­nan­cial cri­sis, val­u­a­tions are high and the UK econ­omy is fac­ing huge head­winds in the face of Brexit.

“If savers are in­vest­ing in UK eq­uity in­come funds for a steady and hope­fully grow­ing in­come stream, they need to be aware of these risks and un­der­stand what kind of fund they own.”

And the risk is high. In­vestors who own a stock that cuts its div­i­dend face a dou­ble whammy of the re­duced in­come pay­ment and a fall in the share price when the cut is an­nounced. Div­i­dend cover is a mea­sure of a com­pany’s abil­ity to pay div­i­dends and is cal­cu­lated by di­vid­ing prof­its af­ter tax by the ex­pected div­i­dend.

A div­i­dend cover of two means af­ter-tax prof­its are twice the div­i­dend pay­out, a com­fort­able mar­gin of safety. But div­i­dend cover of less than one in­di­cates that a com­pany does not have suf­fi­cient prof­its to pay the div­i­dend and will have to sell as­sets, use cash stock­piles or take on debt to make the promised pay­ment. Oth­er­wise the div­i­dend will have to be cut.

A num­ber of big firms have seen their div­i­dend cover fall be­low one, in­clud­ing Shell, BP and Voda­fone. These stocks fea­ture in many eq­uity in­come funds, so any cut in their div­i­dends would hit many in­vestors.

In ad­di­tion, the 10 FTSE 100 com­pa­nies pre­dicted to have the high­est yield in 2017 have an av­er­age div­i­dend cover of 1.3, re­search from AJ Bell, the fund shop, found. Only one had cover of more than 1.5.

One fund man­ager who has reshuf­fled his portfolio to help pro­tect against the risk of div­i­dend cuts is Ed Meier, who re­cently took over the £167m Old Mu­tual UK Eq­uity In­come fund. He re­alised that the 10 com­pa­nies pay­ing the largest div­i­dends in the fund rep­re­sented about 60pc-65pc of the fund’s to­tal yield, and this made him ner­vous. He has now re­duced the fig­ure to 50pc and wants to cut it fur­ther.

How­ever, by re­duc­ing the fund’s re­liance on a hand­ful of big names he has had to move into some higher risk, or unloved, stocks.

“We have moved into a small bas­ket of in­vest­ments that are rel­a­tively high yield and fo­cused on the con­sumer dis­cre­tionary sec­tor,” he said. He ac­knowl­edged that some of these shares ap­peared cheap, re­flect­ing the mar­ket’s con­cerns about them, but said: “This is why the analysis you do on in­di­vid­ual stocks is key, so you have your eyes wide open as to why a whole sec­tor is priced where it is. “It’s a bal­anc­ing act. We also have some names that maybe yield closer to the mar­ket, but have the abil­ity to grow their pay­out.” One ex­am­ple of a stock Mr Meier bought is re­tailer Dunelm Mill, which he called a “stock mar­ket dar­ling that fell from grace”. How­ever, it has a yield of 4pc and a “good bal­ance sheet”.

Bri­tish com­pa­nies’ div­i­dends are look­ing shaky and your funds may not be able to avoid the fall­out, writes Laura Suter

An­other problem is that in­come funds tend to re­sem­ble each an­other. The 10 largest UK in­come funds all have a pos­i­tive “cor­re­la­tion” to each other over five years, mean­ing that re­turns are likely to rise and fall to­gether. “It is easy for in­vestors to think that be­cause they own three, four or five funds they have got a spread of ex­po­sure,” said Ryan Hughes of AJ Bell. “They may own Thread­nee­dle, Artemis and Wood­ford’s in­come funds, which are three very good funds, but they have a lot of com­mon­al­ity in their hold­ings. In­vestors need to un­der­stand the dif­fer­ent in­vest­ment styles, look at the top 10 hold­ings to see where the con­cen­tra­tion of risk lies and start think­ing more glob­ally.”

Data from Morn­ingstar, the re­search firm, found that 15 of the 79 UK eq­uity in­come funds it an­a­lysed re­ceived more than 50pc of their yield from their top 10 hold­ings.

In re­cent years the task of di­ver­si­fy­ing has been made eas­ier as more in­come funds have launched that in­vest ei­ther across the globe or in medium-sized and smaller UK com­pa­nies, mov­ing away from the same old names in the FTSE 100.

Mr Hughes rec­om­mended the New­ton Global In­come fund, a “very solid hold­ing to sit along­side more tra­di­tional UK in­come funds”, and Artemis Global In­come, which he said in­vests very dif­fer­ently from the big UK in­come port­fo­lios.

For in­vestors who want to stay in the UK but spread their risk across more com­pa­nies, the Mon­ta­naro UK In­come fund spe­cialises in small and medium-sized UK com­pa­nies. “It of­ten means look­ing away from the fa­mil­iar names, and it has done a fan­tas­tic job over the past 10, 15 and 20 years,” Mr Hughes said.

‘In­vestors who rely on a hand­ful of stocks for in­come are play­ing a dan­ger­ous game’

Oil gi­ant Shell has lower earn­ings than its div­i­dends, putting it in the dan­ger zone

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