With oil prices depressed, many investors have added a chunk of BP (LSE: BP) to their portfolios in the hope of enjoying a 7.5% dividend yield. I’ve bought some myself.
I believe that within a couple of years, the oil market will have rebalanced and the price of oil will be higher. This should push BP shares higher too, providing an attractive mix of income and capital gains.
So far I’m happy with my decision. Oil production disruption in Nigeria, Libya and Canada are combining with falling US production to help reduce surplus supply. In my view, we may see more definite signs of a turnaround later this year.
Oil majors such as BP are also starting to benefit from lower costs across the oil industry. Consensus forecasts for 2016 earnings rose this month, for the first time in at least a year. A substantial increase in profits is expected in 2017.
If BP’s recovery goes well and the firm’s management continues to focus on cash flow and shareholder returns, I may not sell my shares in BP. I believe this company could prove to be a long-term cash cow for income investors.
History suggests a buying opportunity
Forecast yields of more than 7% are generally regarded as risky by the market. Based on historical statistics, there’s a good chance of a dividend cut. I’m happy to admit that this applies both to BP and to another of my income stocks HSBC Holdings (LSE: HSBA).
HSBC currently offers a forecast yield of 7.8%. That’s very high, but I’m not too concerned about the risk of a cut. This is because my goal as an income investor is to earn a yield above the FTSE 100 average, which is currently 4%.
If HSBC cut its dividend by 25%, the firm’s shares would still offer a forecast yield of 5.8%. That’s plenty high enough to meet my requirement for a market-beating yield. It’s a similar story at BP, where a 25% dividend cut would still give a forecast yield of 5.7%.
Getting back to HSBC, I think a fair amount of bad news is already in the share price. The stock trades at a 35% discount to its book value and on 10-times forecast earnings. I’d be happy to buy more at this valuation, especially as HSBC’s forecast dividend is covered by forecast earnings.
A lower, safer payout?
For more cautious investors, investing in companies with mega yields might not be an option. Luckily, there are a number of quality income plays trading at more normal valuations in the FTSE 100.
One example is BAE Systems (LSE: BA), which has a prospective yield of 4.4% and trades on a 2016 forecast P/E of 12. This valuation seems fairly reasonable, given BAE’s diversity and modest debt levels.
It’s also worth noting that BAE’s dividend has only been cut once in the last 18 years. Since 1999, the payout has risen every year. That’s a fairly good record.
The downside is that a reasonable amount of earnings growth is already baked into BAE’s share price. While I don’t think the defence giant is an outright bargain, I do think it’s decent value for investors looking for a reliable dividend income.