Income stocks are attractive in a low yield world but some are dividend-traps. Tim Bennett looks at the warning signs.

How investors can spot dud income stocks

Dividends can be addictive both for companies and investors: in a low yield world, companies that offer a sustained flow of inflation-beating income are popular. The danger, however, is that in a bid to keep dividends flowing, a firm may start to take on too much risk. So what are the warning signs?

The trouble with “cover”

A popular screening tool when it comes to assessing the safety margin attached to a firm’s dividend is cover – that is the relationship between a firm’s profits before dividends to the annual dividend. The higher the number, the lower the risk. But here’s the problem – according to the Share Centre, the largest 350 UK stocks offer cover of just 0.8 on average. Anything below 1 is traditionally considered to be low and, worryingly, this ratio has fallen from 1.2x in 2015 and 1.4x in 2014. So as an indicator this stalwart of income investors is now of limited use.

A better bet is to look at a firm’s cash flows (a topic I cover in more detail at Killik.com/learn “financial statements”).

Investors should also watch out for three red flags that may suggest a firm is in dividend distress – that is, it getting more and more desperate to maintain its annual dividend and seeking more questionable means to do so.

Taking on extra debt

Borrowing in a low interest rate environment is sensible. However, you need to look at why a firm is doing it. If you see rising debt levels with no corresponding change in sales or earnings and/or evidence that the firm is replacing long-term assets then you may have a firm that is borrowing simply to fund dividends. This is not sustainable.

Asset sales

Another technique a firm may be tempted to use to keep dividends flowing is to sell off assets. This is a double whammy potentially as it tends to be the best assets that are easiest and fastest to sell but clearly this is not a strategy that can be maintained for long. Investors should look for evidence of a mismatch between asset sales and the funding structure of the business. Why? Because in the absence of any signs the firm is using the proceeds from asset sales to pay down long-term debt, it may be that the motivation is to raise cash for dividend payments.

Reduced investment

If a firm needs to conserve cash flow in order to meet dividend payments, it could look to cut back on investment. This may come in the form of reduced R&D and/or reduced capital expenditure. It can be tricky to spot but some warning signs include;

·         Changes in the ratio between R&D expenditure and sales

·         Changes to the assumed useful lives of existing long-term assets as the firm tries to avoid spending money on replacing them

In summary

By themselves, these indicators may not suggest a problem however they are worth monitoring. Where you see more than one combined you should do some more digging into the firm’s cash flows. Otherwise the danger is you maybe sleep walking into a dividend trap when the firm suddenly reins in its dividend, having run out of creative ways to fund it.

To discuss Killik & Co’s dividend screening process, or to discuss individual stocks in the context of dividend risk, please contact an Investment Manager.