Investing for Income – More Than Just Seeking a High Yield

Vanishing Dividends

Every week brings news of a major company cutting or suspending its dividend: this week, it was BT. For investors who rely upon dividends for income, the search for a reliable, sustainable dividend becomes ever harder.

There are no shortage of commentators who believe that most companies should be putting dividends on hold now. Certainly, the story of Easyjet paying out significant dividends on the same day as it requested a bail out from the government struck many as irresponsible. When the economy is so uncertain, they argue, the prudent approach is to safeguard cash in order to be sure that the company can survive the Covid crisis.

Yet the importance of dividends is hard to overstate. Over the last 20 years, the FTSE 100 is down around 15%. But if you had reinvested dividends received over that period, you would have made a significant profit – around 80%^[1].

You could argue that the FTSEs dependence upon dividends demonstrates how it is full of companies that have run out of road. The big dividend payers in the FTSE are in the oil, tobacco and natural resources sectors, mature sectors fraught with regulatory risks. What looks like a secure income is often only an accident or a piece of litigation away from a significant capital loss.

While a high yielding share sounds attractive, it is key to remember that the dividend yield is the amount of dividend a company pays divided by the share price. So, it follows that there are two ways to increase yield: either increase dividend or reduce share price. All too often, it is a falling share price that causes a high yield, which is often followed by the dividend being cut anyway. So never assume a high yield is a positive indicator without further investigation.

Terry Smith wrote an article recently^[2] in which he criticised the concept of “equity income funds” and argued that all investors should be concerned with is the overall return on their investments. Too narrow a focus on dividends leads you too often to companies that can no longer find opportunities for growth.

In a similar vein, Baillie Gifford published an interesting article encouraging investors to focus on “long term income rather than short term yield”^[3] . Their view is that the most secure dividends are paid by companies that can grow their earnings. Focusing on the dividend a company pays today can lead to overlooking the companies that will be growing their yield in future.

You can certainly argue that it makes little sense to focus on dividends. If you own a share, you own a right to a company’s future income. Whether the company pays it out in the form of a dividend or reinvests it makes little difference (other than in terms of taxation, which is a different subject). What matters is the quality of the company and its ability to grow profits. A few examples support this view.

Over the last 5 years, the share price of Centrica has fallen from £2.80 to 40p. The 62p of dividends it has paid in the meantime is scant comfort. For BT, the drop has been from 487p to 105p, with 89p of dividends. Dividends are discretionary, and boards are loath to cut them. So often, when they are cut, it indicates that the company has been in trouble for some time: a message the share price had been communicating much more clearly than the dividend. Centrica recently cut its dividend from 12p to 1.5p, while BT scrapped its altogether. You might conclude that dividends reflect a company’s history better than they indicate its likely future.

On the other hand, if you had been willing to look forward and invest in less established companies five years ago there were bargains to be had which are paying chunky dividends now. Bioventix (BVXP) is popular among many private investors for its very profitable, capital light model. Five years ago, shares were trading at £7.50 and paying a dividend of 32p. Last year, they paid a dividend of 73p. That’s a near 10% yield on the price in 2015. However, it is barely known to income seekers, because it yields less than 2%, as its share price has risen to over £40 during that period. That’s why yield is such a dangerous measure: it flatters companies with weak share prices and overlooks those whose share price is strong. And yet the aim for investors must surely be to identify companies which can increase both dividend and share price in tandem.

One of my holdings, Anglo-Asian Mining (AAZ) had a share price below 5p in 2015. Today it sits at 120p, and paid dividends of 6p during 2019. Had you bought at the right time, you would be receiving more in dividends each year than your original purchase price. I didn’t manage that, but I know a few who did and live off the dividends.

Investing for Income

So, what should people who require income do?

The first thing is to remember Smith’s point: you can always sell shares to generate cash. Anybody who bought shares in Microsoft or Amazon 20 years ago is not going to be regretting the low level of dividends they have received in the meantime. The downside of that approach can be that you end up selling more shares during a market pullback: or “pound cost ravaging” as it is known.

Secondly, if a company has a high yield, ask why. Ideally, it is because the company is consistently growing profits and wants to share truly surplus income with its shareholders. In the worst case scenario, it is indebted, has a share price in a downtrend and a dividend that is unsustainable. Although not an infallible indicator, looking at the dividend cover figure is a first step in understanding how affordable the current level of dividends is likely to be.

Thirdly, investors should be clear about their timescales. As we have seen, dividends today are often bought at the expense of capital gain tomorrow. High quality companies with growth opportunities will generally outperform the market. Any portfolio needs to be constructed with eyes on both the immediate need for income and the longer term requirement for growth. Because it is the successful growth companies of today which will be the dividend payers of tomorrow.

Finally, investors seeking income should consider alternative funds. There are plenty of listed companies investing in non-equity asset classes, from renewable energy and infrastructure to debt and music rights. These are not always immune from capital losses: commercial property, aircraft leasing and student accommodation companies have all been hit hard by the Covid virus. However, many are designed to provide a secure income with a reduced risk of capital losses. They are, perhaps, a better place for many true income seekers to look than high yielding operating companies or equity income funds.

Paul de Gruchy, Director, ShareSoc

¹ It’s difficult to be precise but this article stated a return of over 93% by late 2018: https://www.cazenovecapital.com/uk/financial-adviser/insights/strategy-and-economics/how-the-ftse-100-returned-94-without-moving/

² https://www.fundsmith.co.uk/news/article/2020/04/30/financial-times—investors-never-let-a-crisis-go-to-waste

³ https://www.bailliegifford.com/en/uk/intermediaries/insights/ic-article/2020-q2-the-great-dividend-crisis-pro-ar-0084?p=12557

DISCLOSURE: The author holds shares in Anglo-Asian Mining and is a director and shareholder of GCP Infrastructure Investments.