10 stocks that pass four important dividend tests

With the risk of getting caught in a dividend trap increased significantly, Stockopedia’s Ben Hobson a few important dividend measures all investors should think about.

Cash dividend payouts are highly prized by investors. But at a time when even the best analysts are struggling to figure out what dividend payouts will look like this year, knowing where to look for reliable income is hard.

The latest stats on UK dividends from Link Asset Services came out in April, and cover the first quarter of 2020. At that time, the uncertainty triggered by coronavirus and the oil price collapse was only just beginning to get under way. Since then we have seen mass numbers of dividend cancellations and analysts rushing to try and update their forecasts. 

Link’s numbers show that by 5 April, 45% of companies had scrapped their 2020 payouts - amounting to around £25.4 billion of dividends. More is likely to follow.

While the economy is now likely to be facing a deep recession, the stock market itself has until now been rising steadily. These facts present difficult questions for dividend investors. In good times dividend traps (attractive yields that never materialise) are an ever-present risk. In bad times, the chances of getting caught in a trap like this has soared.

So what checks should income investors be making when they look at the market today? Here are a few important dividend measures to think about...

1. What is the dividend yield?

Dividend yield is one of the best ways of comparing payouts and gauging share valuations. The current average forecast yield across the market this year stands at 3.4% - or £3.40 in dividends for every £100 of shares you hold. But remember that while high yields are appealing, excessive yields can be a warning that the share price has fallen and the dividend may be at risk.

2. Can the company afford to pay a dividend?

Dividend payouts are an important part of the total return that investors get from shares. But in challenging times a company may find it is at risk of not making enough money to fund the payout. That might not be a problem, but consistently low dividend cover (the measure of the company's net income over the dividend paid) can be a warning. Dividend cover of less than 1x suggests the company cannot fund its payout from current year earnings, and you may need to look at why.

3. How much has the dividend grown?

Dividend growth is important for income investors because it points to companies that are doing well and optimistic about their prospects. Growth in payouts also enhances the compounding effects of reinvested dividends over time. Some investors prefer dividend growth to high yield but be aware that some dividend stocks do not raise their payouts very often (but still remain popular).

4. Has the company ever cut its dividend payout?

While long-term dividend growth is desirable, it is just as important to know about dividend cuts. In times of economic jeopardy, dividends are often the first thing to be cancelled. But it is the job of management to try and avoid this where possible. A track record of dividend cuts can be a sign that the company is not fully in control of its circumstances or is being too ambitious with its payout.

Screening the market for dividend shares

With this checklist in mind, this week we have come up with a screen that looks for the biggest companies in the market where yields look set to be reasonable. While many will have cut their dividends in 2020, this screen looks for evidence of a decent track record of dividend growth and forecasts of more growth to come from here.

The results are dominated by some stalwart defensive stocks in industries like mining, utilities and insurance - precisely the kind of safe havens that are traditionally popular in times of economic stress. 

Source: Stockopedia

Looking ahead, the outlook for dividend payouts in the coming couple of years remains uncertain. 

In the meantime, it is more important than ever to be wary of exceptionally high yields and pay close attention to dividend track records and the forecasts that are coming through. 

With the earnings outlook so unpredictable, some sectors are likely to be much more appealing sources of dividends than others - so tread carefully.

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