Investment View: In search of an income? Here’s a steer through the dividend maze

As a general rule, companies try hard not to impose dividend cuts

Do you look for dividends to provide you with an income? If so, watch out. A study by the Share Centre says earnings cover has sunk to a three-year low for the index of 350 leading British companies.

Divide a firm profits after tax by dividends paid and you get a ratio. The higher it is, the more earnings a company is retaining for whatever reason, and the more stable its dividend ought to be. If the number is low, a company might have to consider a cut in the dividend if profits disappoint.

The report says the overall figure is now 1.4 times earnings against 2.3 times in 2011. What’s causing this? The Share Centre used data from its Profit Watch report and Capita’s UK dividend monitor, which together suggest that increases in payouts have been racing ahead of profit growth, particularly in the mining sector.

Mining-company profits are closely linked to the price of the commodities they dig up. These prices have generally been falling. Industrial unrest is another issue, understandably when you have executives on packages topping £10m while in some places the people who do the dirty work struggle to feed their families.

However, commodity prices are volatile and have a habit of swinging back, which means earnings can quickly recover. As a general rule, companies try hard not to impose dividend cuts, sometimes even borrowing to sustain payouts in the hope that earnings will rebound.

That’s because dividends are important – they are your reward for the capital you provide a company to carry out its activities. However, they aren’t the be all and end all. Take the Thomson Reuters study into the world’s 100 most innovative companies. It is based on patents filed, their global reach and how often they are cited. No British company made the list, and part of the reason was the low level of R&D spending.

Maintaining R&D spend ought to be a priority because in many cases it is only through innovation that payments will be sustained. Thomson Reuters has again kindly provided me with a list of the top 10 dividend yields in the FTSE 100 for income-seeking investors. I checked out prospective yields – based on expected future payouts – at Digital Look. Here are my thoughts for people seeking income:

First up is Resolution, the life insurer that owns Friends Provident. Forecast yield is 6.6 per cent, dividend cover 1.2 times. I’ve long been a sceptic, and the numbers don’t encourage me. Avoid.

Royal Dutch Shell has a forecast yield of 5.4 per cent, 2.1 times covered. Trading on 8.5 times forecast earnings, the shares look cheap. Crude prices are at a three-month low but they will rebound. Buy.

AstraZeneca’s forecast yield is 5.7 per cent, 1.8 times covered. Astra has a new CEO who is attempting a turnaround, and has done some interesting deals with the aim of finding new drugs to replace those going off patent. But it’s a risky play and GlaxoSmithKline may be a better bet for income seekers. It’s number 10 for historic yield – 4.8 per cent –which is forecast to rise to 4.9 per cent if the company meets expectations. Cover is at 1.5 times. The shares have eased down and the forecast earnings multiple of 13.6 times is by no means stretched for a quality company. Buy.

Scottish and Southern Energy will be squeezed if Ed Miliband becomes prime minister. Despite claiming falling profits at its retail arm, it’s still handing out an above-inflation dividend rise but the cover is just 1.3 times although the forecast yield (6 per cent) is very generous. At 13.7 times forecast full-year earnings, it’s of speculative interest. But income seekers after stability should avoid. National Grid is still dealing with the buffetting it took in the US from Hurricane Sandy. But it has secured an eight-year deal on pricing/investment in the UK and dividends will rise at the rate of inflation for the foreseeable future. With a forecast yield of 5.7 per cent, don’t be concerned about cover of just 1.3 times earnings. Utilities can afford to operate of low levels of cover because future profits are predictable. The Grid is as near to a sure thing as you will find. It trades on 14 times forecast earnings, not cheap but I’d still be a buyer.

Same for United Utilities, covered 1.2 times, yields just over 5 per cent (forecast). The shares are on 16 times forecast earnings, which isn’t high. Trading on 8.9 times forecast earnings with a 5.3 per cent prospective yield, two times covered, the worst is behind BP. Income seekers should buy because the dividend should rise.

The other two in the top 10 are Admiral and RSA. The former is heavily focused on car insurance, a market I remain wary of because regulators are all over it, even though the prospective yield of over 7 per cent is tip-top. Don’t be tempted. RSA I avoid making a call on because of a personal issue with the company.