Beware the allure of high-yielding stocks

How soaring dividends can mask a world of trouble

VODAFONE was sending all the wrong signals to investors this week when it slashed its generous dividend by almost half.

Many shareholders bought the mobile network over the years precisely because of its dividend payout. Last year it stumped up 13p per share, a total of £2.8bn.

Stocks which yield an income like this can be very useful for savers. Unlike companies which don’t pay a dividend, and simply hope their shares will appreciate in value as the business grows, income stocks give shareholders a tangible sum every year that they can spend or reinvest as they choose.

But Vodafone isn’t the only bighitter losing its mojo. The future of dividends at British Gas- owner Centrica, BT and ITV are also in question, while High Street stalwart Marks & Spencer has already cut its payout by 40pc.

Gervais Williams, who manages Miton’s UK Multi Cap Income fund, says the fact that dividends dished out by heavyweights are shrinking is worrying for investors but, to an extent, it is to be expected.

‘Over recent years, a lot of companies have been more generous in paying dividends,’ he explains.

‘If you don’t need to pay for improvements in your business, and you have got money to pay out to shareholders, then it’s fine. But ultimately, long-term investment return is about generating productivity and improvements from spending money on the business.’

In other words, companies which have been throwing out cash to shareholders to keep them happy – and, more cynically, to increase the share price and boost their

bosses’ bonuses – might suddenly realise they actually need to spend some money on the business.

This seems to be what happened to Vodafone.

As recently as November, chief executive Nick Read was assuring investors there was no need to cut the dividend. But since then, it has had to spend millions buying up bandwidths for high- speed 5G mobile networks in order to keep up with its rivals.

For investors still looking for a healthy income, there are other opportunities out there.

Companies such as steel firm Evraz, housebuilder Galliford Try and Southend Airport-owner Stobart Group all boast a yield – their forecast dividend compared to their share price – of around 12pc.

But Russ Mould, investment director at AJ Bell, points out that a high yield may be masking issues at a company.

For example, a fall in the share price pushes up the yield if the dividend remains the same. But if the share-price fall represents trouble at the company, a dividend cut should follow.

In a recent note, RWC Partners fund manager Ian Lance told investors not to heed the ‘Sirens’ call’ of high-yielding stocks.

‘When stocks start trading on very high dividend yields it often means the market is on to something,’ he says. ‘In the run in to the financial crisis, the market began to sense that all was not well with the banks a long time before the crisis actually hit.’

SOHOW can an investor actually tell whether a dividend stock is worth buying into? Robin Geffen, the founder of Neptune Investment Management, explains he sold out of Vodafone last year because it was building up ‘unsustainable’ levels of debt to fund its expansion, and was facing competition from new, smaller companies that could offer different pricing structures.

Mould advises shareholders to use a bit of maths to work out a

company’s dividend cover, or how much it is earning compared to how much it plans to pay out.

This involves dividing earnings per share by the dividend per share. Anything above two is ideal, and below one suggests danger.

Vodafone, for example, was at 0.76 before the dividend was cut, and Centrica is currently at 0.91.

Among the safest highest-yielding stocks appear to be housebuilders Taylor Wimpey and Persimmon, and HSBC, with dividend covers of 1.13, 1.21 and 1.4 respectively.

Pensions firm Prudential, meanwhile, is predicted to pay a total dividend of £1.4m this year with dividend cover of 2.83.

Savers should also look at a company’s balance sheet to see how much debt it is carrying compared to equity.

To do this, add up long-term and short-term borrowings, minus cash and cash equivalents, divide by shareholders’ funds and multiply by 100.

The higher the percentage, the more worrying the debt levels.

While the high-yielding giants might look like a bargain, Vodafone has shown their fortunes can quickly stall.

Just as Odysseus developed ploys to avoid the Sirens in Greek mythology, investors too have a number of tricks at their disposal to avoid the lure of unreliable dividends.