By Atul Prakash
LONDON (Reuters) - Halfway through Europe's company earnings season, investors who made record bets in search of dividends have cause for celebration, though they should prepare for disappointment from some traditionally high-paying sectors.
Global miner Rio Tinto
That would have been welcome news to those who ploughed more than $1 billion into European dividend funds in January, the biggest monthly sum since the middle of 2011, EPFR data showed.
Investors have been lured to these funds by predictions that aggregate dividend levels in Europe will return to growth this year after holding flat for two years.
According to Markit data, dividends for MSCI Europe (ex-UK) <.MIUG00000PUS> companies will rise 5 percent to 183 billion euros ($250 billion) in 2014 and to almost 200 billion euros next year. More than half of the firms are expected to raise dividends this year, with only 13 percent seen likely to cut.
Investors have therefore pushed Euro STOXX 50 dividend futures for 2014 and 2015 up 2.6 percent and 4 percent, respectively, this year, Thomson Reuters data shows.
However, shares in defensive sectors like telecoms and utilities that generally pay good dividends could underperform the wider market as higher debt levels, further infrastructure investments and a possible rise in acquisition activity hinder their ability to return cash to investors, analysts said.
"In a negative real interest rate environment, dividend-paying stocks perform well as people flock for income. The first place investors have gone for dividends is defensive sectors," said James Butterfill, global equity strategist at Coutts.
"But some defensives are quite expensive now, and we are not sure how sustainable their dividends are, particularly utilities and staples."
The ability of the telecoms and utility companies to pay rich dividends could come under stress as their dividend cover - the ratio of earnings to payouts - hovers at around 1.5 times against a long-term average of 2.0 to 2.5 times, according to industry figures.
In contrast, the ratio for information technology and energy sectors are at 3.9 times and 2.5 times, respectively. Analysts said a dividend cover ratio of 2 or higher suggests a company is in good financial shape to pay dividends, but a level below 1.5 indicates that it might struggle to maintain payouts.
"Watch out, if you care about dividends, that you don't end up in certain sectors. We warn about the strategy that says always pick companies with high dividend yields because they normally outperform," said Ronny Claeys, senior strategist at KBC Asset Management. "If you end up in telecoms and utilities, you end up with sectors having low or no growth."
"Dividend cover is a problem for telecoms, and cutting capital expenditure in the sector seems difficult," he added
Analysts said stocks in these sectors had become richly priced, and disappointing earnings could send investors running for the exit.
"The only strong argument to buy these companies is high dividend yields. But if they decide to reduce dividend payments, there is no reason to buy or hold them," said Christian Stocker, equity strategist at UniCredit in Munich.
"Telecoms and utilities have become very expensive, and probably their earnings will also disappoint. It's better you start looking somewhere else to maximize your returns."
According to Thomson Reuters StarMine data, telecom and utility companies on the STOXX Europe 600 index <.STOXX> are expected to report a drop of 29 percent and 25 percent in fourth-quarter earnings from a year earlier, against a likely drop of 9 percent for the broader index.
Sectors that could get a boost from dividends include energy and healthcare, which have good dividend yields and above-average dividend cover, analysts said.
Drugmakers are in better shape due to their strong product pipeline, while a cut in capital expenditure by energy firms will help them amass cash and pay higher dividend, they added.
"Buy cheaper sectors such as energy and healthcare which have well-above-average dividend cover and continued dividend growth. On the top of that, they have high dividend yield too," said Coutts's Butterfill
(Editing by Will Waterman)