The UK Tobacco Firms'' Dividend Shares Under Threat in 2014

Source from:  Telegraph.co.uk 01/29/2014

Three of investors' most popular sources of income may be about to let them down, research by The Daily Telegraph indicates.

Tobacco makers, utilities and drugs companies have all been seen as reliable dividend payers in recent years, but all are in danger of cutting the income they pay to shareholders each year, according to professional investors.

The fears of dividend cuts in these previously reliable sectors come despite a prediction that overall dividend payments this year will exceed ￡100bn for the first time. The predicted total of ￡101bn would be a 27pc increase over last year's figure of about ￡80bn, according to the Capita Dividend Monitor, although it would be flattered by a huge special payout from Vodafone.

But a number of income fund managers say the big headline figure is unlikely to be achieved. They cautioned that a number of Britain's dividend stalwarts would fail to deliver in 2014.

Two tobacco giants, British American Tobacco and Imperial Tobacco, were highlighted as being under significant pressure to maintain their dividend payouts to shareholders.

Over the past couple of years both shares have been big income payers, but Stephen Bailey, manager of the Liontrust Macro Equity Income fund, said days of big dividend payments were over for the sector.

He described both stocks as a "yield trap". These are shares whose high income payments attract investors but which are in danger of cutting their dividends, or at least unlikely to grow them, making the share price vulnerable. Over the past year the share prices of both tobacco giants have underperformed the market, both posting small losses, whereas the average share in the FTSE 100 is up 11pc.

As a result of the share price falls the yields on both stocks have risen: British American Tobacco currently yields 4.3pc, while Imperial Tobacco's yield is even higher at 5.1pc. This is much higher than most stocks in the FTSE 100 - the index yields around 3.5pc. Yields are paid net of basic-rate tax.

Mr Bailey said investors should not be fooled by the high yields on offer from the cigarette makers, which he said were "high for all the wrong reasons".

Tobacco firms have come under increased regulatory pressure over the past year. Governments have stepped up their health campaigns, with a number of countries introducing plain packaging rules. This has hit profits and in turn weighed on share prices.

Mr Bailey no longer has any of his clients' money invested in either stock, although he has been a big fan of the sector throughout his career.

"Tobacco stocks in particular look to be a yield trap as their emerging market businesses will inevitably follow developed markets into decline," said Mr Bailey. "As a result, dividend payouts will increasingly represent a declining 'annuity' as the business goes into 'run-off'.

"Investors are better off backing shares that can pay dividends while still funding growth in their businesses."

Another area of the market that has been in vogue with income seeking investors but has started to fall out of favour is utility stocks, which include electricity, gas and water firms. Companies in this sector, such as National Grid and SSE, are extremely popular with UK income fund managers because of their high yields and supposedly resilient business models.

But George Godber of Miton has been a sceptic for some time about the sector's ability to continue paying high levels of income to shareholders. Last year Mr Godber and his colleague Georgina Hamilton said their analysis showed that utility firms were not generating enough cash to justify their high dividends. Instead, they had for a number of years been borrowing money, and therefore building up debts, to avoid cutting their dividends.

According to the Capita Dividend Monitor dividend payouts in the utility sector fell last year, indicating that dividend payments had started to come under pressure. Earlier this week analysts at Credit Suisse also issued a gloomy outlook for the sector, predicting that Severn Trent would cut its dividend by 25pc by the end of the year. They also predicted a 20pc dividend cut at United Utilities and took a downbeat view of Pennon's cash generation. "We expect underperformance [in the share prices] to accelerate," they said.

Mr Godber added: "When our opinions on the fragility of utilities' dividends were made public last year it caused quite a lot of controversy. But we think this view has now become more accepted thinking."

Britain's giant drugs makers, GlaxoSmithKline and AstraZeneca, are often found in income fund managers' portfolios - but Jeremy Lang, who oversees the Ardevora UK Income fund, doesn't own a single share in either company. He said investors should not own shares that were heavily reliant on outcomes beyond their control.

While GlaxoSmithKline and AstraZeneca both yield just shy of 5pc, Mr Lang cautioned that their future profits depended heavily on future drug discovery.

"I would rather buy relatively safe shares that are geared to the improving UK economy and pickup in consumer spending," he said. "I own shares such as Berendsen, the dry cleaning business, and holiday firm Tui Travel.

"I would sooner own stable businesses that rely on consumer spending, as opposed to companies that need to come up with new product innovations to maintain top-line growth."

Separately, research from Sanlam Private Investments has found that 14 UK equity income funds managed to grow their dividends by more than inflation over the past five years. Enditem