Uncertainty over dividend payments could see defensive shares back on top
MARKS & Spencer was hit by shareholder anger last week after it confirmed a widely flagged decision to slash its dividend payout to shareholders by one third. It saw its shares dive to the bottom of the FTSE 100, wiping 8 per cent off the share price in just one day. The price has continued to fall since, and now stands at 284.25p. The payout cut, which comes after eight consecutive years of dividend increases, is a blow for the retailer’s army of small shareholders, who hold an estimated quarter of the shares.
But as M&S executive chairman Sir Stuart Rose said the decision was “straightforward common sense” given the economic uncertainty.
PREVAILING TREND
And the retailer is merely following the prevailing trend: BT and mining group Anglo American have both recently cut their dividend payouts, while last week airline British Airway axed its dividend altogether. BA’s decision came after last year’s dividend was actually the first it managed to pay out since 2001.
In most cases the move marks a sensible decision for the company. Paying out dividends hits corporate profits – already under huge strain due to the recession. Meanwhile, the Pensions Regulator has already told companies to prioritise scheme payments over dividends – a decision Dairy Crest took recently when it cut its dividend payout by a quarter, whilst putting £20m into its pension scheme.
If a company is planning a rights issue, as so many are currently, then it makes little sense to give shareholders back cash, while at the same time asking them for more. Waste management group Shanks made exactly that decision last week.
Yet while it might make corporate sense, for investors it can wipe out a lot of the point in investing in shares in the first place. Rough estimates indicate dividend reinvestment and growth account for the lion’s share of total returns – somewhere between 50 to 90 per cent. Capital gains are a far smaller part of the investment rationale.
The fact that dividends, once the stable earnings winner, for shareholders, are rapidly becoming as unreliable as earnings, means that the rationale for investing in shares over, for example, government bonds is becoming far less attractive.
FURTHER FALLS
Derivatives exchange NYSE LIFFE recently launched a contract based on its expectations of FTSE 100 dividend payouts. It currently estimates that dividend payouts will fall by 30 per cent next year.
This is on top of the 19 per cent fall in payouts since last Summer’s peak.
Typically, the long established way to measure a dividend’s reliability is the dividend cover: that is, the ratio of net profits to the size of the dividend payout.
Generally, a cover ratio of around two – when the company has twice as much net earnings as the amount earmarked for dividend payments – is considered a strong indicator.
But, according to UBS investors there are two other factors an investor needs to consider; the price of crude oil and the strength of sterling. Oil companies, it calculates, account for a third of FTSE 100 dividends. If the price of oil per barrel falls below $50, it would expect them to cancel dividends. Meanwhile, an estimated half of blue chip dividends are declared in pounds – its currently rising strength against the dollar and euro therefore is a concern.
On this basis, coupled with easing credit conditions, UBS suggests National Grid, Pennon, Inmarsat, Reed Elsevier, G4S and Whitbread, as companies which should maintain their dividend payouts next year.
Generally, defensive sectors, which are expected to perform steadily regardless of the economic background, are also seen as a good bet.
Scottish & Southern Energy, which last week raised its payout by nine per cent marking it as one of the highest yielding companies in the FTSE 100, is a typical example. Aside from utilities, pharmaceutical, oil and tobacco companies also typically provide reliable income streams.
For all those small investors who sold off their M&S investments last week, the kind of companies listed above could provide a better place to park their cash.