Smart beta to deliver dividends as declining profitability hits dividend sustainability

Jul 7th, 2016 | By | Category: Equities

The affordability and sustainability of dividends paid by FTSE 350 companies has dropped to its lowest level for seven years, signalling that dividend cuts could be on the horizon. In this environment, income-focused investors might be wise to look to smart beta exchange-traded funds that focus on companies with a strong capacity to maintain dividend payments. Indeed, recent research suggested there is a growing need for innovative approaches to income investing to address issues such as the quality and sustainability of dividends (see Growing need for sustainable income ETF strategies).

Smart beta ETFs deliver dividends as FTSE 350 coverage ratio drops to 7-year low

The weighted average dividend coverage ratio for the FTSE 350 has fallen in the past year from 1.63x to 0.98x, raising doubts about the sustainability of dividend payments by UK companies.

According to research from UK retail stockbroker The Share Centre, the dividend cover ratio of the FTSE 350 index is now at its lowest level since Q3 2009. This ratio (net profit after tax divided by dividends paid) is typically seen as a gauge of a company’s ability to service and maintain its dividend. A higher ratio suggests a greater capacity to maintain a dividend level while a lower ratio suggests that a cut in the payment may be needed.

Recently companies have – on average – paid out more in dividends than they made in profit, raising questions concerning the sustainability of their current levels of pay-out. The weighted average dividend cover ratio for the FTSE 350 has fallen by 38% in the past year alone, dropping from 1.63x to 0.98x. Net profits have fallen by 54% to £76.4bn, while dividend payments have risen 10.1% to £78.4bn over the same period.

Helal Miah, research investment analyst from The Share Centre, said in a statement: “Plummeting profits in the FTSE 350 have undermined dividend cover across the board, even before the impact of a Brexit vote is fully felt among listed companies. Global headwinds took their toll on the UK’s largest, most internationally exposed sectors, with commodity firms and banks especially seeing their profit margins and dividends under increasing pressure. However, more worryingly for investors, the stress on dividend cover has been rather more widespread, and not limited to a small cluster of sectors.”

Firms operating in the basic materials (predominantly mining companies), oil and gas, and financials industries, have been hit hardest by global headwinds as falling commodity prices hit producers’ profits and negative interest rates impacted banks’ margins. Within the broader basic materials industry, the mining sector saw dividend cover turn negative (-1.06x) as miners reported losses of £7.7bn in 2015. With a similar loss of £8.0bn among oil and gas producers, this sector saw dividend cover fall into negative territory – a drop mirrored by oil services and distribution companies. In the banking sector, dividend cover fell from 1.61x a year ago to 0.52x.

For the remaining firms, the weighted average dividend cover stands at 1.65x, reflecting a fall from 1.84x a year ago. The consumer services sector performed relatively poorly with cover falling from 1.75x to 1.10x in the last year, while the health care sector bucked the wider trend as, driven by the pharmaceuticals industry, its cover ratio rose from 0.99x to 1.69x.

Mid-cap companies are faring relatively better than their larger-cap peers in terms of dividend cover with a ratio of 1.56x for the FTSE 250 compared to 0.89x for the FTSE 100. Over the past year the FTSE 100 has experienced a 34% fall in net profits, compared to a 7% increase in the FTSE 250. These fortunes may reverse however as market reaction to the Brexit referendum result suggests that FTSE 250 profitability will deteriorate as the economy slows.

According to Miah, “Finance directors will usually try to ride out a soft patch for profits and hold the dividend steady for as long as they prudently can. Eventually, it is important to face facts. We have already seen companies announce a slew of dividends cuts, many of which are still to filter through. This will protect companies from unaffordable outflows of cash. In an ideal world, investors would see dividend cover recover owing to a bounce-back in profits, rather than from cuts in the dividend. With the outcome of the Referendum likely to hit profits of companies dependent on the UK economy, investors should expect cover to fall further or brace themselves for dividends to be cut; they should be cautious of companies that have a combination of a high yield, and a low cover.”

Income investors concerned by this development should be reassured by index construction methodologies underpinning a number of smart beta equity income ETFs which utilise screens to favour fundamentally stronger firms with more sustainable dividends.

Examples of such ETFs include the SPDR S&P UK Dividend Aristocrats UCITS ETF (LSE: UKDV), linked to the S&P UK High Yield Dividend Aristocrats Index. This ETF tracks the performance of the 30 highest dividend-yielding UK companies within the S&P Europe Broad Market Index that have increased or maintained their dividends for at least 10 consecutive years. This fund has assets of £80m and comes with a total expense ratio (TER) of 0.30%.

Another is the Source FTSE RAFI UK Equity Income Physical UCITS ETF (LSE: DVUK), which tracks the FTSE RAFI UK Equity Income Index. This ETF follows a more quantitatively oriented fundamental approach by screening stocks according to financial health (profitability, debt servicing ability and accounting quality) before selecting constituents and weighting them according to dividend yield. This fund has assets of £39m and has a TER of 0.35%.

A third such option is the BMO MSCI UK Income Leaders UCITS ETF (LSE: ZILK), which tracks the performance of the MSCI UK Select Quality Yield Index. This ETF selects the highest 50% of constituents in the MSCI UK Index with the most favourable ratings as determined through an analysis of return on equity, year-over-year earnings growth low financial leverage. A second screening stage selects the 50% of the remaining securities with the highest dividend yields. This fund has assets of £13m and has a TER of 0.35%.

Of course, ETFs such as these are not immune to declining profitability among UK companies, but their smart beta methodologies certainly make them better equipped to navigate such an environment and avoid dividend yield traps.

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