*Why dividends are being slashed

From David Stevenson, across the river from the City

Dear Money Morning Reader,

Dividends are on a downer.

European companies will be reducing their dividend payments over the next 18 months at the fastest rate since at least 1999, according to Gareth Gore and Adam Haigh at Bloomberg.

That's very nasty news for those who need their stocks to produce a good income. And longer term, it undermines one of the main reasons for holding shares, as we explain below.

Fortunately there is something you can do about it.

The Dow Jones Euro Stoxx 50 Index Dividend Future exchange-traded derivatives contract is a bit of a mouthful. But what it lacks in the snappy-name stakes it more than makes up in usefulness. It was launched last year to let traders take a view on the distributions that will be made by the stocks in the underlying Euro Stoxx 50 index.

In a nutshell, it's a dividend predictor. And what it's forecasting right now isn't exactly music to the ears of income seeking investors. European companies are expected to slash their dividends in 2009 by 28% compared with last year. Worse, in 2010 a 32% decrease is in the pipeline.

Beware optimistic earnings forecasts

Although there's an anomaly here – analysts currently expect company earnings to rise 10% this year and 22% in 2010 - that's unlikely to provide much solace. Individual stock research is often far too upbeat. As Société Générale's Andrew Lapthorne puts it, analysts are factoring in some "clearly wishful thinking" on company profit margins. Plenty of bullish forecasts will "require downward adjustment". In other words, profits will be falling as well as payouts to shareholder.

So why these savage dividend cuts? For one thing, companies are clearly raking in less money due to the recession. "There are still a lot of overstretched companies out there who see cutting the dividend as an easy way to reduce leverage" - i.e. their borrowings - says Bob Parker of Credit Suisse Asset Management, "we're going to see more of that as companies do all they can to improve cash flow".

And more firms are finding it harder to pay the interest bills on their corporate debt. Although there's been some improvement over the last few months, "spreads remain at very elevated levels by historical standards", says Kenneth Emery, Moodys' Director of Default Research. In plainer English, that means the market's still very worried that more companies will default on their debt.

The growing pensions black hole

But the dividend decline has been going for some time. Last year, total dividends paid by UK-listed firms fell by 13%, says Citigroup. 18 FTSE 100 members of the FTSE 100 have cut their dividends in the past year. So is there another, more sinister, reason for the payout jitters?

As we've pointed out - Why company pensions might not be so safe - many company pension schemes have been falling badly into disrepair. By April this year, the overall deficit accumulated by Britain's private sector pension funds had grown into a £240bn black hole. And apart from closing their in-house pension plans, like Barclays and Morrisons last week, one way that firms are plugging their pensions gap is chopping the shareholders' payout.

Dividend cutting is becoming the norm. "Most disheartening of all is the increased willingness of company boards to abandon their payouts", says Tom Stevenson in The Telegraph, "when ICI did it in 1981 there was shock in the City. But the current crop of cuts has been greeted with a weary shrug of acceptance". But there's another key point about payouts. Dividends may appear the "icing on the cake" says Stevenson – if your shares are rising by 20% annually, the dividend's a handy top-up. But long-term, payouts are much more important than this – they are the cake.

Why dividends are crucial

According to Barclays Capital's 2009 Equity Gilt Study, £100 invested in UK stocks in 1945 would have been worth £5,721 by the end of last year if you had spent your dividends, but £92,460 if you had re-invested them in more shares. 94% of the total return from shares since the war has come from dividends and not rising share prices.

To get the best from shares, you need to hold those that, at the very least, maintain their payouts. What's more, if you can find safe high-yielders, there's a good chance you'll outperform the market as well as getting a decent income. Even a fund manager like Newton's Tineke Frikkee, who believes fears of widespread cuts have been overdone, still spotlights top-flight 'defensive' companies as the place to be. We're talking here about firms that don't depend on a strong economy to make money and who've committed to maintaining their dividends for the year ahead.

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Turning to the markets...

The JSE all share index closed up 0.07% yesterday. The gold mining index climbed 2.08%. Resources grew 0.83%. Banks and financials added 0.05% and 0.27% respectively. Industrials slumped 0.01% and the platinum mining index gained 1.47%.

London’s FTSE100 closed down 0.01%. The Dow Jones lost 0.02% and the Nasdaq jumped 0.96%.

Tokyo’s Nikkei closed 1.1% up. Hong Kong’s Hang Seng added 3.05%.

Brent crude is currently trading at $70.59 per barrel.

Spot gold’s trading at $961.15 and platinum was last quoted at $1,259.00.

And here’s how the rand is performing against the major currencies:
R/$ 8.04
R/£ 13.20
R/€ 11.34

Until next time,

David Stevenson

Associate Editor, MoneyWeek UK