Dividends have been a significant component of the historical total returns enjoyed by shareholders of BAE Systems (LSE: BA) and Vodafone (LSE: VOD). Right now, the shares of these two FTSE 100 firms are well down from their 52-week highs — over 25% and over 33%, respectively.
These declines have pushed their prospective dividend yields up to significantly higher levels than previously. The defence giant sports a yield of 4.5% and the telecoms colossus offers a whopping 8.9%. Investors today have the opportunity to snap up what are very juicy yields, compared with the firms’ historical norms.
Furthermore, if their dividends prove sustainable, their share prices should make new highs, in due course. From current levels, this would imply upside of 35%+ for buyers of BAE and 50%+ for buyers of Vodafone.
Great opportunity
I view the defence sector as an attractive one for investors, because geopolitical uncertainty is a perennial theme and drives robust spending on defence by governments. BAE’s size, and status as a leading and trusted player, makes it a great pick as a core holding for a blue-chip stock portfolio, in my opinion.
Aside from 2003, when the company maintained its dividend at the same level as the prior year, it has increased its payout annually since at least the start of the century. Its record has been one of not extravagant, but steady, growth. And it’s forecast to continue, with annual increases of between 2% and 5% pencilled in for the next three years.
I mentioned BAE’s current 4.5% yield is high, relative to its historical norms. Similarly, its price-to-earnings (P/E) ratio of 11.7 is cheap by historical standards. Management has said any near-term impacts from Brexit are likely to be limited, and I think we’re looking at a high-quality business that’s been dragged down largely by the general weakness of equity markets over recent months. As such, I see a great opportunity for investors, and I rate the stock a ‘buy’.
Investing
While BAE’s 4.5% yield and annual payout increases appear assured for the foreseeable future, you don’t find a stock yielding as high as Vodafone’s 8.9% without there being a relatively elevated risk of a dividend cut. The company’s accounting earnings don’t currently cover the dividend. However, free cash flow does. So what’s the issue?
Vodafone is investing for the future. It’s agreed to acquire US group Liberty Global‘s operations in Germany and Central and Eastern Europe for €18.4bn. The deal, which is subject to regulatory approval, is expected to complete around the middle of the current calendar year. At the same time, the spectrum auction cycle is in a phase in which Vodafone faces above-average annual expenditure to acquire spectrum.
Balancing act
Management reckons the group’s balance sheet can tolerate the increase in debt, necessary for these investments. And it believes it can maintain the dividend at the current level, before returning it to growth when financial leverage reduces.
If the company can pull off this financial balancing act, the rewards for investors from the current level — at which the market is evidently pricing-in a dividend cut — are likely to be substantial. On this basis, and seeing the depressed share price as providing some downside protection, if the dividend were to be rebased, I rate the stock a ‘buy’.