Outperforming fund manager Neil Woodford tells us in his latest blog post that he's not afraid to make judgements about the sustainability of a company's dividend even if his opinion goes against what the directors say.
Beware of the big oilers
Right now, he thinks BP(LSE: BP) and Royal Dutch Shell(LSE: RDSB) are financing their dividends by taking on debt and disposing of assets rather than from cash flowing in from operations. He says: "In effect, these companies are liquidating themselves rather than facing up to the need for a dividend cut."
It's hard for big, traditionally-dividend-paying firms to cut the payout. There's a lot of pressure not to. How many investors with a dividend-led investing strategy hold BP and Shell on the grounds of sector diversification, or justify them by the high level of the dividend yield. And how many fund managers keep the firms in their portfolios for similar reasons? Many I suspect, so that's a lot of retirement funds hinging on the dividend performance of the big oil firms and a lot of responsibility piled onto the directors' shoulders.
Yet the dividends will fall, Woodford reckons, saying: "The only thing that can save them from that eventuality, in my opinion, is a return to sustainably higher oil prices - something that I think is very unlikely to happen."
Spending above their means
We need to look no further than the consolidated cash flow statements for BP and Shell to see that over the last two years, operational cash inflow has not been enough to finance the capital investments these firms are making, as well as the dividends they are paying. The net outcome is that gross debt is rising and cash balances on the balance sheets are falling - dividend payments are eating into the rainy-day funds and running up debt on the metaphorical credit cards.
The situation is enough for Woodford to keep BP and Shell out of his funds and we should keep them out of our portfolios too, in my view. When dividends are cut down to size or abolished altogether, it rarely works out well for investors. As well as a loss of income, you need to buckle up ready for a plunge in the share price and prepare for capital losses from your portfolio that could end up being permanent.
Is there trouble elsewhere?
Neil Woodford's simple analysis of dividend sustainability strikes me as an essential check for other dividend-paying companies that may be lurking under the disguise of an attractive dividend yield and a well-known company name. Maybe the oilers are not the only dodgy dividend payers you are holding? If I find one in my portfolio I won't think twice about dumping it.
It's also interesting to learn that Neil Woodford thinks the price of oil will struggle to return to former high levels. The longer the oil price languishes, the more the high prices of recent years start to look like a bubble. That line of thought calls into question any strategy that involves speculating that the price of oil will recover. Maybe it's time to reappraise the prospects of smaller oil firms and oil services businesses too.
Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.