As markets march higher and higher it's become increasingly difficult to find the high dividend yields that used to characterise the UK's largest listed equities. But while many income investors may be lowering their normal high standards to find big yields, there are two huge dividends out there that I would avoid at all costs.
The first is education materials company Pearson (LSE: PSON). Shares of the company have collapsed over 50% in the past two years due to five successive profit warnings. These were caused by a slowdown in demand for its physical textbooks among cost-conscious students, falling enrolment in the US as the economy improves, and a shift towards online education across the globe.
Management has so far been able to maintain the dividend at 52p, which works out to an 8.1% yield, but the company's results over the past five years show it's becoming increasingly likely that shareholder returns will be slashed sooner rather than later.
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Adjusted Operating profit (£m)
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These results are adjusted for the sale of large units such as The Financial Times and The Economist and thus reflect the dramatic slowdown in the group's core unit. A further worry, aside from the increasingly low dividend cover, is that free cash flow last year was only £310m and didn't cover the £424m paid out in dividends.
This is the second year running that this has happened and with net debt rising £438m in the year to £1bn, or 1.4 times EBITDA, it's incredibly unlikely management will be able to afford uncovered dividends in 2017 without seriously threatening the group's balance sheet.
With analysts expecting a further 16% fall in earnings in the year ahead amidst a highly competitive market and rapidly changing consumer habits, I reckon Pearson's big dividend yield is not going to last very long.
I wouldn't take the other side of this bet
Another big dividend that's on my blacklist is outsourcing firm Carillion (LSE: CLLN). Despite offering an 8.6% dividend yield that is covered by earnings, the stock is the most shorted across the LSE.
This is due to several factors but most analysts are suspicious that Carillion has avoided profit warnings that have plagued rivals such as Capita and Mitie. The company's proponents argue that due to its large construction segment it is not as vulnerable as these competitors to cost overruns and subsequent writedowns to the value of contracts.
Yet in 2016 these support services accounted for a full 68% of the £268m in underlying operating profits. This means any problems in this segment will be hugely negative for the company's overall profitability and ability to pay out dividends, construction segment notwithstanding.
Furthermore, with net debt during the year averaging £586m and the pension deficit rising to £663m, the company's balance sheet is looking increasingly stretched just as margins compress and growth stagnates.
Even if short sellers' worst fears are unfounded, Carillion remains an indebted, low-margin, low-growth business in a highly cyclical industry. These characteristics alone are enough to keep me away from shares of the company.
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Ian Pierce has no position in any shares mentioned. 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.