Invesco’s Barnett warns of dangers of dividend traps

Invesco Perpetual’s head of UK equities Mark Barnett has urged investors not to be tempted into stocks simply on the back of high dividend payouts.

The manager of the £6.5bn Invesco Perpetual Income and £12.3bn High Income funds points to Tesco’s recent profit warning, the supermarket giant’s third this year, as a prime example of where investors need to be careful when looking at companies with historic high dividend yields.

The manager, whose top holdings include dividend paying stalwarts such as British American Tobacco and AstraZeneca, says: “Investors continue to succumb to the temptation of high but unsustainable yield – they fall headlong into the so-called yield trap, discovering after purchase that the underlying company’s high profits the previous year were not repeatable and that the shares were ‘cheap’ for a reason.”

Barnett explains that the headline dividend yield of a company is only part of the equation and that stocks offering a high yield might simply reflect weak short-term price performance, owing to a deteriorating profits outlook, rather than because the company’s success has been overlooked by the market.

He adds: “I tend to look at a company’s dividend yield in the context of its long-term profits outlook, and relative to its competitors.

“I would rather invest in shares of a company on a 3 per cent starting yield with excellent growth prospects, than a company on a 6 per cent where I see a high risk of a significant dividend cut.”

Notably the latest and well-observed Dividend Monitor from Capita Asset Services highlighted how UK plc third quarter dividends disappointed, where underlying payments dropped by 2.9 per cent year-on-year, while headline payouts were basically flat, after edging ahead by just 0.2 per cent. On the back of the results, Capita cut its full year forecast for 2014 to £97.1bn. 

However despite Barnett’s words of caution he admits he is heartened by the rising dividend payout ratio of the companies in the FTSE All-Share. Here he notes companies in general, rather than retaining their profits for a rainy day or for capital investment, have been paying out a higher percentage of earnings by way of a dividend.

Given this backdrop he believes it seems probable that total market dividends will grow more closely with the underlying earnings of UK-listed companies in the coming year and consensus for earnings growth for 2014 is about 3.6 per cent.

He says: “I would therefore expect market dividend growth to be in line with this level. Naturally, there will be some companies which cut dividends and others which grow them by more than the average.

“While it is true that equities continue to look attractive relative to other asset classes, many valuations still look elevated where, in my view, share prices do not appropriately anticipate the risk to earnings and cash-flows the underlying companies are facing.”