The Income Investor: are BP and Rio Tinto a buy for dividends?

Income investors face a continual trade-off between risk and reward. At asset class level they can hold cash or government bonds to generate a relatively reliable, albeit historically lacklustre income return. Or they can purchase assets such as equities that offer the prospect of inflation-beating dividend growth in return for a higher chance of income volatility.

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There are also wildly differing risk/reward income opportunities within the stock market. Some companies, such as utilities and tobacco stocks, have historically offered stable income returns. Others, in contrast, have produced wild variations in dividend payouts that, while proving to be relatively high over the long run, have fallen heavily during periods of temporarily weak economic growth.

An improving global economic outlook

Industries such as energy and basic materials, which include oil & gas and mining companies, respectively, are often among the most volatile income stocks due to their financial performance being heavily reliant on highly changeable commodity prices.

While they have experienced an uncertain period over recent years amid a weak global economic outlook that could persist in the short run, their relatively attractive yields, stable financial positions and improving operating prospects mean they could be worthwhile income investments on a long-term view.

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After all, the world economy’s period of rampant inflation, rapidly rising interest rates and weak economic growth is now in its latter stages. While sticky inflation means the exact timing of interest rate cuts in the US, Europe and the UK may be subject to change, significantly looser monetary policies are ultimately set to be introduced over the coming years. In the US, for example, the Federal Reserve’s latest forecasts show that it expects a gradual decline in interest rates over the next two years so that they stand at around 3.1% in 2026.

Lower interest rates should, all things being equal, have a positive impact on global economic activity levels. This should raise demand for, and the prices of, a wide range of commodities and provide improved operating conditions for oil & gas and mining companies.

Stronger financial performance is likely to prompt increased dividend payments, since in many cases shareholder payouts represent a pre-determined percentage of overall profits, as well as capital growth that further enhances total returns for income-seeking investors.

Favourable risk/reward opportunities

While energy and basic materials companies have experienced a period of elevated uncertainty, in many cases their financial positions remain sound. While a solid balance sheet does not equate to robust dividend payments, since shareholder payouts are generally dependent on profits, it means that the risk of permanent capital loss is relatively low.

A solid balance sheet should also allow for any growth in profitability to be passed on to investors in the form of higher dividends. Indeed, a firm that enjoys a sound financial position will not necessarily need to use a large proportion of profits to reduce net debt or shore up its balance sheet.

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In any case, the heightened volatility of profits and dividends among oil & gas and mining stocks appear to be factored into their yields. Since they are generally higher at present than those of companies operating in more stable industries, as well as the wider stock market, they provide a margin of safety for income investors in case profits temporarily fall and dividends are cut.

Relatively high yields also compensate long-term investors for the prospect of delays to falling inflation, declining interest rates and higher activity levels for the world economy.

Of course, high yields and solid financial positions do not eradicate the inherent income volatility of oil & gas and mining stocks. Investors who require a stable income stream will therefore almost inevitably find them undesirable. But for investors who can take a long-term view and look beyond heightened dividend volatility in the near term, buying a range of financially sound resources stocks with attractive yields could mean obtaining a generous income return as the world economy’s outlook gradually improves.

Source: Refinitiv as at 9 April 2024. Bond yields are distribution yields of selected Royal London active bond funds (end February 2024), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 5 April. LIBOR is interest rate that banks lend money to one another (3 month GBP LIBOR as at 28 March). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 9 April.

BP

BP (LSE:BP.) has a relatively attractive dividend yield despite its share price rising by 73% over the past three years. The oil & gas company currently yields 4.4%, which is 60 basis points higher than the FTSE 100’s yield, with dividends rising by 18% in its latest financial year. Payouts were covered a healthy 2.8 times by profits, which shows there is scope for dividends to rise at a faster pace than the company’s bottom line over the coming years.

Of course, oil and gas prices have been highly volatile in the recent past. This has contributed to volatile profitability for sector incumbents, with BP’s profit more than doubling in 2022 before subsequently halving in its most recent financial year. Although its dividend remained resilient, volatile profits could ultimately be directly felt by investors in the form of highly changeable shareholder payouts.

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With net debt falling slightly in the company’s most recent financial year, it now has a modest net gearing ratio of just 25%. This shows that it has the financial means to overcome periods of lower oil and gas prices, while future profits do not need to be used to rapidly repay debt. In fact, the company’s robust cash flow provides it with sufficient capacity to raise dividends, conduct share buybacks and reinvest in its asset base for future growth.

With BP’s shares currently trading on a price/earnings (PE) ratio of just 8, they offer a wide margin of safety and scope for significant capital growth. While the inherent volatility of the company’s profits has been evident in recent years, and could persist in future, an attractive yield, solid financial position and generous dividend cover mean the stock remains a highly worthwhile long-term income investment.

Rio Tinto

Mining stock Rio Tinto Registered Shares (LSE:RIO) currently yields 6.7% despite cutting shareholder payouts by 12% in its latest financial year. Dividends were reduced in response to a decline in earnings of the same amount, with the company choosing to maintain its 60% dividend payout ratio rather than leave shareholder payouts unchanged. This highlights that while dividends can fall during leaner years, the maintenance of payout ratios means there is scope for income levels to rise significantly should profits increase amid a more upbeat global economic outlook.

In terms of diversity, the firm remains heavily dependent on iron ore. It accounted for 78% of profits in its latest financial year. Although the steel-making ingredient has a bright future due to its widespread usage in renewable energy infrastructure that is set to be in high demand as the world transitions to net zero, the company’s dependence on it raises overall risk.

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That said, Rio Tinto is investing heavily in other areas, notably copper, which provide diversification benefits alongside long-term growth potential. Meanwhile, its net gearing ratio of 8% and net interest cover of 36 highlight its solid financial position that means debt reduction is unlikely to be a serious consideration in the near term. And with a PE ratio of 8.9, the stock’s risk/reward ratio is highly appealing due to it offering substantial capital growth potential.

Clearly, Rio Tinto’s dividend payments could prove to be relatively volatile as a result of the company’s high degree of dependence on commodity prices. Given its modest payout ratio, attractive dividend yield and improving long-term financial outlook, however, the company is an appealing income stock for investors who can accept the potential for large-scale fluctuations in their dividends.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.