It’s easy to write off a dividend stock when its yield sails above the market average. Indeed, it’s generally considered that a yield of more than the market average is unsustainable.
However, this isn’t aways the case. Even if a company can sustain its dividend payout but the market believes it can’t, then the negative sentiment will push the share price down and the yield up to what appears to be an unsustainable level.
And this is exactly what has happened with two of Neil Woodford’s favourite dividend stocks Legal & General (LSE: LGEN) and Capita (LSE: CPI).
Dividend doldrums
Legal & General appears to be the dividend stock everyone loves to hate. In the aftermath of the Brexit vote, shares in the financial giant collapsed by more than 35% and are still trading more than 7% below their pre-Brexit high. Growth concerns have kept investors away from the company during the past few months although City analysts are still forecasting earnings per share growth of 14% this year and 1% for 2017.
What’s more, for the interim period to August 9, Legal reported that net cash generation had risen 16% to £727m, relative to adjusted operating profit up 10% to £822m and post-tax profit up 22% to £667m. These numbers show Legal is converting 109% of its post-tax profit to cash, which is an impressive cash conversion metric — few companies manage to hit the 100% cash conversion barrier — and it could be why Neil Woodford has chosen to invest 5% of his income fund in the business.
At current levels, shares in Legal support a dividend yield of 6.2% and trade at a forward P/E of 10.6. City analysts expect the company to increase its dividend payout by around 1p per share next year indicating a dividend yield of 6.9% for 2017.
Profit warning
Shares in Capita are down by 40% since the end of September when the company issued a profit warning and investors instantly rerated the shares. Before the warning, investors had been willing to pay up to 16 times forward earnings for Capita’s shares but now shares in the company are trading at a lowly 9.2 times forward earnings.
Still, as the shares have plunged, the company’s dividend yield has skyrocketed. At the time of writing shares in the company support a dividend yield of 5.4%, nearly 2% above the FTSE 100 average.
Capita’s dividend payout is well covered by earnings per share, so there’s little reason to worry that the profit warning will weigh on the payout. Last year the dividend payout was covered 2.2 times by earnings per share and City analysts expect a similar level of coverage this year despite the fact that EPS are projected to contract by 4%.
With a 5.4% dividend yield that’s well covered, it’s easy to see why Neil Woodford’s Equity Income fund holds a 3.2% position in Capita.
