The Income Investor: why I’m still a buyer despite dividend cut
This FTSE 100 company has been a reliable income generator over the years and still pays a handsome dividend. Analyst Robert Stephens believes investors shouldn’t be put off by a recent cut.
by Robert Stephens from interactive investor
Dividend cuts can prompt significant disappointment among income investors. After all, shareholders of a company that reduces its dividend will receive a lower income than they did previously. This can have a negative impact on their financial circumstances.
Of course, long-term income investors who hold a variety of dividend stocks are likely to experience a reduction in shareholder payouts from at least one of their holdings at some point in time. The risk of this occurring may presently be elevated, given the uncertain near-term economic outlook and its potential impact on company earnings.
Income investors, though, should resist the initial temptation to immediately sell any stock that has reduced its shareholder payouts. Instead, they should first seek to understand why its dividend has been cut. Indeed, it is important to deduce whether the reduction represents a temporary measure that is likely to be followed by a return to dividend growth in future, or if it is the start of a period of sustained cutbacks in shareholder payouts.
Fundamental strength
For example, a company that has been forced to cut dividends due to it having bloated debt levels may struggle to grow shareholder payouts in future. Certainly, interest rates have fallen by 75 basis points over the past seven months and are expected to continue this trend in the coming years, thereby reducing debt-servicing costs for many firms. However, with inflation forecast to reach 3.7% this year, according to the Bank of England, interest payments may remain high for some time yet.
Similarly, a firm that has recorded a sharp fall in profitability due to a weak competitive position may be unable to raise dividends at an inflation-beating pace in future. Ultimately, its weak market position could equate to lacklustre profit growth even during upbeat operating conditions. And with dividends being paid from profits over the long run, there may be better opportunities for investors to obtain a growing income available elsewhere
Source: Refinitiv as at 12 March 2025. Bond yields are distribution yields of selected Royal London active bond funds (as at 31 January 2025), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 10 March. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (7 Mar). *Data prior to May is based on 3-month GBP LIBOR. Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 12 March.
Margin of safety
Of course, some companies are more prone to dividend cuts than others. Firms operating in industries that are inherently cyclical, for example, are likely to experience greater variance in their financial performance, and therefore dividend payments, than companies in defensive sectors.
Mining companies, for instance, are highly dependent on the world economy’s performance due to its impact on commodity prices. Investors in such stocks may therefore wish to obtain a margin of safety at the time of purchase that compensates them for the greater likelihood of a dividend cut.
This is likely to be achieved via a higher dividend yield than that available across much of the wider stock market. It means that even if dividends are temporarily cut due to weak market conditions, investors in the firm are likely to still receive a generous income return relative to that available elsewhere in the stock market.
Managing risk
In addition, companies with modest payout ratios may be less likely to cut dividends than those firms which pay a higher proportion of profits to shareholders. Such firms may be able to maintain dividends without compromising their capacity to reinvest for future growth and strengthen their balance sheet, even amid a temporary decline in their profits.
As ever, diversifying across a wide range of companies can lessen the impact of dividend cuts on an investor’s overall income. Although this will not eliminate the threat of dividend reductions, it means that investors who are reliant on their holdings to provide an income stream, are likely to enjoy more stable payments vis-à-vis their peers who have a relatively concentrated portfolio.
Short-term challenges
FTSE 100-listed Rio Tinto Registered Shares
RIO recently cut its dividend. The mining company reduced shareholder payouts by 8% in the 2024 financial year. This mirrored a decline of the same amount in its earnings per share that was largely due to a lower iron ore price. The firm’s reduction in shareholder payouts means that it now has a dividend yield of 6.4%, which is 300 basis points higher than the FTSE 100 index’s income return. As a result, it appears to offer a margin of safety in case there are further dividend cuts ahead.
In the short run, the company’s shareholder payouts could come under further pressure due to an uncertain global economic outlook. Rising inflation across developed economies including the US, UK and the eurozone means that the pace of monetary policy easing may slow.
This could lead to a moderation in growth expectations that prompts reduced demand for a range of commodities. In turn, this may reduce their prices and hold back Rio Tinto’s financial performance, thereby prompting a further decline in its dividend. And with China, which is the world’s largest importer of iron ore, facing an uncertain near-term outlook, it would be unsurprising if the firm’s bottom line comes under further pressure in the near term.
In addition, the company has a dividend policy whereby it aims to pay between 40% and 60% of earnings to shareholders. Its payout ratio remained at the upper limit last year for the ninth year in succession, which suggests that there is little scope for a reduction in dividend cover in the near term. This means that shareholder payouts are likely to closely track profits for the time being.
Long-term potential
Of course, the company’s solid fundamentals mean that it is in a strong position to overcome an uncertain period for the global economy. Its net debt-to-equity ratio, for example, is just 9%, while net interest costs were covered 66 times by operating profits during the latest financial year. A solid balance sheet provides the firm with the financial capacity to further diversify its operations, thereby gradually reducing its longstanding reliance on iron ore, through continued reinvestment and M&A activity.
This could act as a catalyst on its bottom line and dividend growth prospects. The firm’s increasing exposure to a variety of future-facing commodities, such as copper and lithium, means that it is well placed to capitalise on growing demand as the world continues on its path towards net zero. And with the long-term prospects for the global economy being upbeat, with further interest rate cuts ultimately likely to be implemented, the company’s financial performance is set to improve. This should allow it to grow dividends over the coming years.
Risk/reward ratio
Trading on a price/earnings ratio of 9.4, Rio Tinto appears to offer a wide margin of safety. This suggests it has scope for significant capital gains after falling by 2% over the past year. Indeed, it is down by 6% since first being discussed in this column during April last year.
While its recent share price performance, as well as its dividend cut, are undoubtedly disappointing, the company’s income potential remains relatively upbeat. Its solid fundamentals, sound strategy and the prospect of an ultimate improvement in its operating conditions, suggest that the stock is still a worthwhile long-term income opportunity.
Robert Stephens is a freelance contributor and not a direct employee of interactive investor.
