Am I nuts being out of AstraZeneca (LSE: AZN), British American Tobacco (LSE: BATS) and BP (LSE: BP) when they have such tempting dividend yields?
At a share price of 4,017p, City analysts forecast that AstraZeneca will yield a dividend of 4.8% for 2016, at 4,115p British American Tobacco’s forward yield is 4%, and at 341p BP’s is 8%.
Better than cash
Those potential returns are better than anything I can get saving cash, so investing in big firms on the stock market looks attractive.
The problem is that shares can go down as well as up and it’s natural to worry that shrinking capital values might erode any gains from dividend income in the years ahead. However, if I pick the right companies, it’s worth taking the risk. After all, shares can go up as well as down and capital gains from rising share prices could augment my gains from dividend income.
AstraZeneca and British American Tobacco both expect their forward earnings to cover their dividend payouts around 1.4 times during 2016. Both firms produce consumable goods that customers love to repeat-purchase. Tobacco products and medicines tend to be high on the purchase list of consumers that need them.
Such market dynamics keep the cash flowing and that shows in the consistency of the dividend records for these two companies. Over the last five years, AstraZeneca has produced a flat dividend and British American Tobacco has raised its annual payout by around 30%. On top of that, over the same five-year period AstraZeneca’s shares are up around 34% and British American Tobacco’s near 70%.
A different tale
The story is different at BP. Over five years the dividend has been patchy due to the after effects of the firm’s Gulf of Mexico oil spill and the share price is down around 28%. BP doesn’t produce cash-generating consumer goods like the other two. Instead, it produces a commodity that’s at the mercy of fluctuating market prices.
Right now, the oil price is down and BP expects its forward earnings to cover the dividend payout less than 0.5 times during 2016. The firm’s dividend looks vulnerable, and if I invest in BP now I need to take a view on where the price of oil might be going in the future.
Because of the cyclical nature of BP’s operation and the fact that earnings recently collapsed, the firm’s valuation looks odd. For 2016, the company’s forward price-to-earnings (P/E) ratio sits at 28, whereas AstraZeneca’s sits at 14.5 and British American Tobacco’s is 18.
I’m more nuts being out of AstraZeneca and British American Tobacco than I am being out of BP. An investment in BP looks speculative and seems to net out to betting on a rising oil price. Whereas, based on their business models, it seems reasonable to expect further steady operational progress from AstraZeneca and British American Tobacco. AstraZeneca’s patent-cliff-induced slide in earnings seems set to halt in the coming years as new drugs come through from the firm’s development pipeline to bolster earnings. British American Tobacco expects its earnings to rise by 9% during 2016 and a further 8% in 2017.
