A big warning for income investors

Disastrous profit warnings are rare events in FTSE 100 companies, but we got one this week from the consumer finance group Provident Financial.

In amongst a barrage of bad news - which slashed its share price by nearly 70% - Provident cancelled its interim dividend and said its full-year payout was unlikely.

For a £2.6 billion stock with a 7.7% yield, this dividend cut was a very big deal. It showed just how careful investors have to be with eye-catching, high-yield "Dividend Dogs" that can end up in disappointment.

A dog's dinner

Provident's difficulties have been known for some time. In fact, analysts have been cutting their earnings forecasts aggressively since the spring. In June, it warned that profits were under pressure because of big changes in the way it was operating.

With the latest warning, the profit outlook was slashed as those problems continued. With the all-important dividend suspended, the CEO had little choice but to fall on his sword.

But, while some had earlier voiced concerns about Provident, others felt the problems were overblown. Fund manager Neil Woodford argued that its difficulties were short term and that the dividend was "unlikely to be affected". Woodford maintains that the investment case is intact.

From a broader perspective, it's likely that Provident's 7.7% yield (8.2% forecast) was enough for many investors to ignore its problems.

Indeed, for the past three months Provident has been in an exclusive club of popular shares known as Dividend Dogs. These types of stocks often perform very well, but they also come with risks.

Understanding the risks of Dividend Dogs

The term Dividend Dog is affectionately given to the highest-yielding blue chips in the market. We regularly mention them in this column.

They're the focus of a high-yield income strategy that's set out by Michael O'Higgins and John Downes in their book, Beating the Dow. It aims to buy the 10 highest-yielding stocks in an index of leading shares - like the Dow Jones or the FTSE 100 - and then hold them for a year.

The simplicity of this Dogs approach is a big attraction to investors. The theory is that the highest-yielding stocks are usually out of favour for some reason, and their depressed share prices push the yields up further (hence these are "Dogs").

Interactive Investor's sister website Money Observer runs a similar strategy, its Dogs of the Footsie portfolio. You can read the latest update here.

The flipside is that their size and financial muscle means they'll likely recover and come back into favour - paying off for their shareholders.

But there are flaws with this approach. In the UK, the bulk of dividends in the FTSE 100 have traditionally come from a group of stocks in just a few sectors. So, buying the top 10 yielding shares in the index could leave an investor highly exposed to sector-specific trouble.

You only need to see the pressure on dividends in recent years in sectors like energy, mining, banking and supermarkets to know the risks of over-concentration.

In addition, the Dividend Dogs strategy offers very little in the way of safety nets that might pick up the sorts of problems seen at Provident.

In fact, it was only after Provident issued its first profit warning in June - when the falling price pushed up its yield from 4.4 to 5.5% - that it qualified as a Dividend Dog.

This was arguably a dangerous time to own it - and certainly didn't offer the sort of rock-solid dividend sustainability that many income investors want.

Dealing with those dangerous dogs

Dividend strategies typically fall into one or a combination of three key approaches: high dividend yield, dividend growth and dividend safety. Ahead of the problems that emerged at Provident earlier this year, it had a decent track record of dividend growth and the payout was reasonably well covered.

So, arguably it was the high yield itself in recent months that was the biggest warning of problems. The decline in price drove up the yield as the market lost faith in the stock.

As a result it ended up with a higher yield than some of the best known high-yield shares around, including BP and Royal Dutch Shell.

This makes it a classic case study in one of the most well-drilled risk warnings associated with dividend stocks - be wary of very high yields. They can often be a mirage and one of the early warning signs of a dividend trap.

As for the Dividend Dogs strategy - a solid 9.2% return (before dividend payouts) over the past year from a version of the strategy tracked by Stockopedia, suggests that all is well. Typically, the strategy rules drive it into the arms of some of the biggest and best-loved dividend stocks in the market.

In terms of price performance it does suffer periods of downward pressure, but the yields help insulate it from downturns. Just occasionally, though, it can misfire with a false positive that ends in a dividend trap like Provident. Fortunately, these cases are rare.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.