Protecting your portfolio income from dividend cuts

As 80-20 Investors know I'm regularly asked by the national press for my views on investing. This week a national newspaper asked me for my view on the worrying trend of FTSE 100 companies cutting their dividends.

While 80-20 Investor primarily focuses on growth I appreciate that a number of members also take income from some of their investments. That is why I also produce income focused research pieces such as The best funds for monthly income.

As an 80-20 Investor member, below you can read my full response to the questions (with a few additional insights too) that I was asked about investing for income. The questions were:

• Eight major FTSE 100 companies have cut their dividends this year, including Sainsbury's and Tesco, and this week, Anglo-American. Why are they doing this?
• Why is it bad news for income seekers? What does it mean for your pension income?
• Why are dividends important to private investors, even if you don't hold individual company stocks?
• Will investors see lower income going forward?
• Also, for those investors who buy direct stocks, could you name a couple of promising company dividends?

My response:

Why dividends have been cut

Typically companies will cut their dividend in the wake of a profit warning or an actual fall in earnings/profits.

One possible reason for a fall in profits may be ‘macro’ as in the case of Anglo-American. Tumbling commodity prices driven lower by concerns over Chinese economic growth has hit earnings and the profitability of mining companies such as Anglo-American. The result has been industry-wide cost cutting and in the case of Anglo-American the slashing of its dividend.

Other reasons for dividend cuts include increased competition and/or industry shifts brought about by technology. For example, UK supermarkets are coming under increased pricing pressure from the rise of discount stores such as Aldi and Lidl.  On top of that there’s been a big shift in consumer behaviour favouring local stores and online shopping over the huge out of town megastores retail giants have built their businesses upon. All this has hit profits leading to the dividend cut by Sainsbury and Tesco.

But also company specific problems can increase the chances of a dividend cut, such as Tesco’s failed overseas ventures which hit company profits.

Why is it bad for income investors and what does it mean for your pension income?

Dividend income is one of the few ways to generate an inflation beating income stream in retirement (bond income tends to remain level) if you plan to use income drawdown as opposed to buying an annuity. So if dividends are widely cut that means the income generated by an income portfolio drops. In addition for those who directly invest in the shares of these companies they will see the value of them fall (as investors ditch them in search of income elsewhere). This only becomes a problem if they then follow suit and sell at a loss. Furthermore as they then seek to replace their income stream, but with a now smaller capital sum, they can be left chasing higher yielding shares (and therefore riskier shares and more unreliable dividends).

Even if you don’t hold individual shares, funds investing in those shares will see their payouts and capital values hit, but to a lesser degree. Interestingly not many funds focus on ensuring that their payouts grow year on year. A fund's payout is derived from the dividends of all the companies that the fund invests in.

Dividend outlook in 2016

Unfortunately the recent cuts in payouts from FTSE 100 companies looks set to continue. In fact income investors should expect a fall in dividend payouts in 2016 compared to 2015. While UK dividends grew by 5.8% in 2015 they are only expected to grow by 3% next year.

Yet there have been warning signs that a change in fortunes was on the cards. For example. since 2009 UK companies have been increasing the share of their earnings that they payout as dividends (called the payout ratio). Yet the growth in their dividends has significantly outpaced the growth in their earnings. Something had to give and with concerns remaining over future global growth, headwinds abound.

The natural response of an income investor who buys shares directly would be to retrench into stocks from more reliable industries when it comes to dividend payout consistency (i.e pharmaceuticals). Yet reliable income paying industries might also soon come under threat. Pharmaceutical companies are facing increased competition (while having large dividend payout ratios) and tobacco companies face the rise in popularity of e-cigarettes. Well known dividend payers such as GlaxoSmithKleine and AstraZeneca could even come under pressure as they both have dividend payout ratios of more than 100%. Or in other words they pay out more in dividends than they currently earn. Of course the average payout ratio for different industries varies but excessive payout ratios are still a cause for concern.

What should you invest in to protect your income?

I would generally avoid buying individual shares for the very reason that you are 'putting all your incomes in one basket'. Instead I'd prefer to pick an equity income fund that invested across the market cap and with a reliable payout history (i.e a track record of increasing payouts year on year). The outlook for income from mid-cap shares is perhaps more favourable than large caps at the moment. The trouble is that there are very few funds that make the grade. In fact one of the only funds that does is Evenlode Income. The fund has increased its income payout every year since it launched in 2009 and has around 30% of its assets invested in small and mid cap stocks (i.e outside of the FTSE 100). It also has a current yield of just under 4%.

I’d also favour investing in an investment trust with a track record of growing its payout (such as the City of London Investment trust which has increased its dividend for 49 years in a row!). Don’t forget investment trusts can smooth payouts in good and bad years unlike unit trusts.

If I had to pick individual shares then I'd opt for companies that don’t have excessively high payout ratios (so are less likely to cut their dividend) and offer a fairly decent yield. So I’d go with BT Group and the retailer Next.

Yet Investors should remember that there are plenty of global opportunities for income too and they don’t just have to invest in the UK. Tip: if you do look at investing in a global income fund check the UK equity exposure as a number of global income funds have been criticised for being too UK focused despite their global label.

If you would be interested in a complete analysis of all the income funds out there and which ones pay the most reliable income stream let me know and I will publish it in the new year.

 

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