Investors chasing income should test whether a company can fund its dividend before they look at the size of the yield, according to Dominic Younger, manager of the CT Progressive Income trust.
Dividends matter more the longer the holding period, he explained, because over shorter periods, share price movements “tend to dominate investment returns” but over the longer term, dividends “become increasingly important, particularly when reinvested to benefit from the power of compounding”.
The yield – the annual dividend divided by the share price – can rise for a bad reason: if a share price falls faster than the payout, the yield climbs, which can lead to dividend traps, where that high yield comes just before a cut.
“The sustainability of those payments matters just as much as the yield itself. Some companies maintain high payouts even as profits and cash generation weaken, potentially relying on borrowing or asset sales to sustain them,” Younger said.
Boards hold dividends up because they are “reluctant to disappoint shareholders,” even though a lower-than-expected payout can itself hurt the share price.
For these reasons, two shares can offer the same yield for opposite reasons.
“A 5% yield from a business facing long-term structural decline is very different from the same yield offered by a fundamentally sound company experiencing a temporary setback,” he said.
“Identifying genuine opportunities demands detailed research into a company’s cashflows, balance sheet and long-term prospects to determine whether its dividend is sustainable and its shares offer genuine recovery potential.”
In a recently published white paper, Younger argued that “no quantitative screen or passive investment product can reliably distinguish between the two”.
“It requires an understanding of the competitive dynamics of the industry, the web of personalities involved, the trajectory of cashflow generation and a clear-eyed view of balance sheet resilience in a downside scenario,” he said.
By applying this philosophy, Younger noted CT Progressive Income is naturally more exposed to shares that the market has marked down and looking for a rebound, adding that there are plenty of examples at present.
“The current opportunity set is as rich as we have seen in years. Interest rates are closer to their long-term averages, while the valuation gap between highly valued market favourites and overlooked companies remains wide,” he said.
Alongside the income opportunity, Younger noted that buybacks, where a company purchases its own shares, add about two percentage points to UK shareholder distributions. Meanwhile, with about three-quarters of UK-listed revenues coming from overseas, the market is not the same as taking a view on the domestic economy.
There are risks to the approach, however.
“Investment styles inevitably move in and out of favour, sometimes for extended periods. The challenge is identifying businesses whose low valuations reflect temporary difficulties rather than a permanent deterioration in their prospects, and this requires patience and discipline,” he said.
“Dividends are never guaranteed, but we believe companies capable of sustaining and growing their payouts can offer considerable value to long-term investors.”
CT Progressive Income – renamed in October from CT UK Capital and Income – has raised its dividend every year since its launch in 1992, “a record we remain committed to extending,” Younger concluded.