Is GlaxoSmithKline's 6% Dividend Sustainable?

| About: GlaxoSmithKline (GSK)

There are some amazingly high dividend yields on offer these days, most notably from some of the largest blue-chip shares in the market.

The question, as always, is whether or not those massive yields are sustainable.

Take GlaxoSmithKline (NYSE:GSK) as an example.

It is one of the world's leading pharmaceutical companies, it has a market cap of £68 billion and its record of increasing or at least holding the dividend goes back into the last century.

And yet this keystone of many a portfolio (including a certain Mr. Neil Woodford) is available to buy with a dividend yield approaching 6%.

That's an income of 6% from a company where the dividend has grown by almost 6% a year over the past decade and more.

So why is Glaxo available with such a high dividend yield when other blue-chip dividend growth stocks, like beverage giant SABMiller (OTCPK:SBMRY), can only manage a paltry 1.7% yield?

The answer, of course, is that the market expects Glaxo's dividend to be cut and SABMiller's to continue to grow rapidly for many years.

But the gap between Glaxo's and SABMiller's yields is so large it looks as if the market doesn't just expect Glaxo to cut and SABMiller to grow, it is virtually certain; as if no alternative outcome were even possible.

Such unerring certainty is unusual, and I think that perhaps some other factor is at play.

What we might be seeing, rather than an excess of crystal ball-gazing certainty, is a split in the market.

The split is between those investors whose primary focus is on predictable earnings and dividend growth and those for whom such growth is a secondary or even irrelevant factor.

Tony Yarris of Wise Investments summed up this market bifurcation nicely in a recent article.

His position is that the financial crisis made investors more cautions, and as a result many of them homed in on predictable growth companies.

These companies tend to provide repeat-purchase products or services like household consumables (e.g. beer in the case of SABMiller) or subscription software from companies like Sage (which I reviewed recently for BullBearings.co.uk).

Companies in that predictable sweet spot have seen their valuations explode upwards. SABMiller for example has gone from about 1,000p pre-2009 crisis to 4,000p today.

On the other hand Yarris suggests that dividends, for whatever reason, have fallen out of favor.

For the predicable growth companies, dividend yields are tiny, but that doesn't matter because their growth is predictable and that's all that matters (according to this world-view).

Companies like Glaxo may well offer a 6% yield, but the dividend has a question mark hanging over it, even though the company has reaffirmed its commitment to sustaining the dividend and in fact announced a special dividend to go on top of that 6% basic dividend.

But no matter. Growth is not certain and so the predictable growth crowd are not interested.

As a result companies where dividend growth is less than 99% certain are trading with yields that are normally reserved for basket cases.

In some ways this is a problem.

It makes it harder to differentiate between quality dividend-payers who are simply having a bit of short-term trouble, and those companies that really are value traps, with dividends that are almost certain to go the way of the Dodo.

Unfortunately there is no way to know for sure which is which, but there are a few things you can look for.

Here are some of my investing rules of thumb which are relevant in this situation (to find out more about the investment strategy into which these rules of thumb are built, have a look at these free resources).

Be wary of a company that:

  • Has skipped a dividend in the last 10 years
  • Has failed to grow its revenues, earnings and dividends more than 50% of the time over the last 10 years
  • Has total borrowings greater than five-times its five-year average profits
  • Has total pension liabilities greater than ten-times its five-year average profits
  • Has spent more on acquisitions this year than it earned in profits
  • Has repeatedly spent more on acquisitions over the past 10 years than it earned in profits
  • Has a tendency to acquire companies that have little to do with its core business
  • Has recurring capital expenses that are greater than its profits
  • Has low levels of profitability, especially if ROCE is consistently below 7%
  • Has no obvious competitive advantages

Glaxo currently manages to pass all of those tests, so in my opinion it is not obviously a value trap, even if it does have a 6% dividend yield.

Of course I do not know if it will cut, hold or even grow its dividend over the next five years, but for now I am happy to keep Glaxo in both my personal portfolio and the UKVI model portfolio.