Why I think these downtrodden income stocks will recover

Our writer considers two income stocks that have recently had their dividends slashed. He believes the good times will return.

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With inflation putting a squeeze on my finances, I take comfort from having income stocks in my portfolio. I try not to worry about short-term market movements. Instead I console myself that whatever is happening in the UK stock market, the dividend payments will keep on coming.

Recently, a number of well-known companies have cut their dividends. Given the slowdown in the UK economy, this is to be expected. But I’ve take a look at two of them, to see whether this is a temporary blip, or an indication of a more fundamental problem.

Building

In July 2022, when Persimmon (LSE:PSN) last paid a dividend, its stock was yielding 13.2%. The company declared 235p a share for its 2021 financial year. In 2022, this was reduced to 60p. This year, the directors have stated that they want to “at least maintain” the payout to shareholders.

The construction sector is particularly vulnerable to rising interest rates and the consequences for household incomes.

Last year, Persimmon completed 14,868 houses. But towards the end of the year, there was a marked slowdown in sales enquiries and its order book started to shrink. Although it’s too early to make accurate predictions, the expectation is for 8,000-9,000 completions in 2023.

Based on the current number of shares in issue, a dividend of 60p per share would cost £192m. Even with a 50% collapse in earnings this year, it should be well covered by the company’s profits. As a proportion of profit before tax, it’s much lower than some previous payments.

It therefore might be a case of under-promising and over-delivering.

YearDividend (pence)Profit before tax (£m)Cost of dividend (£m)% of profit paid as dividend
20182351,09174869
20191101,04135134
202023578475096
202123596775078
20226073119226

Insurance

The directors of Direct Line Insurance Group (LSE:DLG) decided not to pay a final dividend after announcing a poor set of results for 2022.

The company’s operating profit fell from £590m in 2021, to £32m in 2022. The 95% reduction in earnings was blamed on soaring inflation and unusual weather.

The company’s solvency ratio (a measure of financial stability) fell from 160% to 147%. It’s still above the required 100%, but the trend is downwards.

In May 2022, the stock was yielding 8.9%. Now it’s 4.7%.

In my view, the problems affecting the insurance company are unlikely to last. Inflation is expected to fall, which means increases in the cost of repairing damaged vehicles will ease. An increase in premiums will also offset this.

Last year was particularly bad for storms, and extremes of hot and cold temperatures. This resulted in a higher level of claims than anticipated. Although not impossible, it’s unlikely that this will be repeated in 2023.

And since the end of 2022, the company has become more solvent.

What do I think?

I’d be comfortable having both of these income stocks in my portfolio.

In fact, I already own shares in Persimmon. And despite the problems at Direct Line, its stock is now on my watch list for when I’ve some spare cash.

Both stocks look relatively cheap to me. Their current share prices reflect the expectations of lower profits. But as the economy recovers, and inflation eases, both should see their earnings rise. Increased payouts to shareholders should then follow.

Finally, I can see that even after their dividend cuts, the stocks are presently offering a better yield than the UK stock market average.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Beard has positions in Persimmon Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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