Income-hungry investors who have been tempted by the high yields of mining giants BHP Billiton and Rio Tinto are seeing their dividend investing strategy backfire, casting doubt over the wisdom of chasing after yield.
But, investors need to realise that depending on cyclical sectors to pay steady dividends was always going to be a risky strategy. Volatile commodity prices and demand which fluctuates according to business cycles meant free cash flows needed to fund dividends were never going to be dependable for long.
Until recently, many investors thought BHP Billiton and Rio Tinto were exceptions. They believed that because they were some of the lowest cost producers globally, they could always generate enough cash flow to pay consistently high payouts. With hindsight, we can now see how this was wishful thinking.
Defensive sectors
Defensive sectors have always been better places to look for reliable dividend stocks. Though not completely immune to dividend cuts, these companies tend to generate more stable cash flows with whatever economic conditions thrown at them.
BAE Systems (LSE: BA) is one such defensive stock. Hit hard by defence spending cuts in recent years, the company is now making a recovery. Sales and operating profits are expanding at their fastest paces in five years, growing 7.6% and 15.5%, respectively, in 2015. Robust growth is coming from both defence and civilian markets, with growth markets, such as cyber security, intelligence and electronics, offsetting slowing demand for military hardware.
Looking forward, recovering defence budgets in key US and European markets should lead to continued revenue and earnings growth, underpinning a steady outlook on dividends. BAE’s 4.2% dividend yield seems secure, as it is covered by almost 2.0x earnings; it is also supported by a strong balance sheet, with net debt of just £1.4bn.
Water utilities
Shares of water companies have long been seen as reliable dividend investments. This is because the predictability and transparency of their regulated revenues and capex plans means these companies can estimate with a high level of accuracy their future free cash flows.
Nevertheless, water companies are not free from risk. Every five years, Ofwat, the water regulator, conducts a price review to set out what they must commit to deliver during the period and the price they may charge customers. After its 2015 review, Severn Trent (LSE: SVT) made a 5% cut to its dividends this year, in order to fund a 5% cut in average household bills by 2020.
Severn Trent and Pennon Group (LSE: PNN) have another four years before their next regulatory review, giving investors a very high degree of visibility over dividend payments until then.
Shares in Severn Trent and Pennon Group both yield 3.9%, but Pennon has a slightly better dividend outlook. Pennon has pledged to increase its dividend by 4% above RPI inflation until 2020, whilst Severn Trent is just targeting above RPI inflation growth.
These stocks may not be the highest yielding ones on the market today, but they are relatively attractive compared to other safe forms of investments, such as savings and bonds. And unlike most other safe assets, water stocks act as a good hedge against inflation.
What’s more, with expectations that the Bank of England will delay raising interest rates until well into 2017, or possibly later, these reliable dividend stocks should remain in favour for longer than many analysts had previously expected.