Why you should beware of tempting but unsustainable yields
By
Deputy Editor
Tim Bennett Jul 18, 2008
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Dividends are key to successful investing. A pound invested in British shares in 1900 would have grown to £161 (ignoring inflation) by the end of 2006, but a far more impressive £21,174 with dividends reinvested, reckons ABN Amro. So the fact that dividend yields – the annual dividend as a proportion of the share price – have fallen as share prices fall is of great interest to most investors.
Banking stocks look particularly mouth-watering – the forecast average 2008 yield is around 11%, more than double the FTSE 100 and comfortably above the 6.5% or so interest rate offered by the best internet savings accounts. Within the sector, Barclays offers 12.5% and RBS 10.8%. This apparent generosity isn't limited to banks. General retailers offer an average of over 7%, with household names such as Marks & Spencer and JJB Sports offering 9.2% and 11.9% respectively. So is it time to fill your boots? No – certainly not yet at least. Here's why.
Dividend yields may look high, but anyone using today's yields to justify a market bottom – the point of maximum fear when huge yields point to cheap shares – is clutching at straws, says the FT's Neil Hume. At around 4.4% the trailing FTSE All-Share dividend yield is at its highest since March 2003, when the last bull ran began. But it's still below the ten-year gilt yield of 4.9%. For the 2003 buy signal to be repeated (ie, for the dividend yield to rise above the ten-year gilt yield), the All-Share "needs to fall another 13%".
High yields come at a price
So what of the yields of 10% or more available from individual bank and retail stocks? These look too good to be true "and probably are", says MoneyWeek's Paul Hill. No one knows the full scale of the damage done to bank balance sheets "by decades of reckless lending".
Banks won't easily lend to each other just now, and Bradford & Bingley's recent disastrous attempt at a rights issue highlights how hard it is to raise funds in the equity market. The prospect of more subprime-related writedowns makes further big share-price falls likely. Meanwhile, retailers are faced with consumers at their most pessimistic since the 1990 poll tax riots; Sports Direct's Mike Ashley has described current current conditions as "the worst for 25 years".
So how can you tell if that high yield is sustainable or not? Simple – check the dividend cover. That's one year's "profits available to ordinary shareholders" from the profit and loss account, as a multiple of the total annual dividend. Two is the absolute minimum in this climate, otherwise there is a severe risk that the last dividend will not be repeated. Tellingly, cover for banks right now is only 1.59 and for general retailers 1.94.
Cash flow is key
Maintaining dividends, not to mention staying in business, in an economic slowdown depends on generating decent "free cash flow" (FCF), not just profit. FCF is the "operating cash flow" from the top of the cash-flow statement, adjusted for "non-discretionary" expenses that a firm must meet, such as the capital expenditure needed to keep the firm operational. FCF should consistently cover the total annual dividend at least once, or ideally more.
However, the ongoing scramble for capital among British banks reflects mounting cash-flow difficulties, while the sizeable falls in retail sales now being reported – 9% in the case of high-street stalwart John Lewis – point to looming trouble. No one can guarantee that today's dividends – which are ultimately "discretionary" cash flows – will be maintained as vulnerable firms are forced to cut spending. In short, high yields in today's markets are not suggesting that stocks are cheap – they're warning that dividends are unsustainable.
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