Having it covered

With the FTSE 100’s earnings cover currently below 1.8 times, David Prosser discusses how investment companies could provide an answer for income seekers.

Are large companies paying out more in dividends than they can really afford? That’s the suggestion of stockbroker AJ Bell, whose first-quarter “Dividend Dashboard”, published last week, warns that the highest yields on FTSE 100 Index stocks “are starting to look questionably high”.

Overall, the blue-chip index is currently offering a prospective yield of 4.4 per cent for 2018, which looks attractive in the current low-interest rate environment. But that yield has been artificially inflated by the weakness in the markets seen during February and March; not only are dividend forecasts unchanged, but analysts such as AJ Bell question whether the current level of pay-outs is sustainable for many large businesses.

The stockbroker’s analysis suggests the average FTSE 100 company’s earnings cover – the extent to which its earnings (as measured by post-tax profit) cover the cost of its dividend – is currently running at 1.71 times. That doesn’t leave much margin for error given the competing priorities for resources within every business.

Amongst the most generous yielders, cover looks even more meagre. Eight out of 10 of the highest-yielding stocks in the FTSE 100 currently have earnings cover below 1.5 times. “Dividend cover of around 1.5 times is less than ideal because it means a company has less room for manoeuvre if profits fall in one year,” AJ Bell warns. “It will then need to decide whether to reduce its dividend, stop reinvesting in the business or take on more debt.”

The analysis is a reminder of the risks of investing for income through a portfolio consisting of equities. High-yielding shares may well offer more generous pay-outs than miserable bank and building society accounts, but their pay-outs may not be sustainable – plus there’s always the danger of capital losses.

Where, then, does that leave income-seeking investors who want better rates than cash is able to provide? Well, there is one type of equity where company managers’ priority is to preserve the dividend; moreover, these companies have tools available to them to work towards that goal.

Step forward investment companies, with their ability. Not only are investment companies run entirely with the aim of providing returns to investors – the conflicting priorities of, say, investment in new plants and machinery, aren’t issues compared to conventional businesses – but they are also able to build up reserve funds.

These reserves are crucial. The typical UK equity income investment company currently has earnings cover of around 1.1 times in place. That sounds quite skinny, but the average fund in the sector also has reserves that provide underpinning of the dividend of an additional 0.7 times.

What these funds are effectively doing with their revenue reserves is squirrelling away cash to pay dividends in the event that their portfolios do not generate enough income to underpin pay-outs. Their priority, in other words is to safeguard the dividend.

Over time, the value of this approach is very clear. The average UK equity income investment company managed to increase its dividends by around 5.6 per cent last year. But more importantly, there are several dozen investment companies that have been able to increase their dividend in each and every year over an extended period – more than 50 years in the case of the market leaders.

This is not to suggest investment companies would never cut dividend payments – and they too carry a risk of capital losses as well as gains. But unlike the businesses in AJ Bell’s analysis, where current levels of earnings cover should worry income-oriented investors, closed-ended funds have a back-up plan.