* Cuts give pause for thought on move into dividend plays
* Investors focus on cash flow, sustainability of payouts
* Demand rises for longer-dated dividend futures
* Telecom dividends to fall further, autos to rise-Markit
By Toni Vorobyova
LONDON, Nov 27 (Reuters) - A run of high-profile dividend cuts by European companies is forcing investors to become more sophisticated in how they use them to make money, pointing money toward derivatives and companies with lower but safer payout levels.
Dividends have become an increasingly popular strategy as investors seek fresh sources of steady returns due to the damage the financial and euro zone debt crisis has done to yields on the safest government bonds - now below inflation.
But unlike bond coupons, dividends can easily be cut. Steelmaker ArcelorMittal, France Telecom and Telekom Austria have all done just that in recent weeks amid weak demand and pressure to keep prices low.
With telecoms and materials among the sectors forecast to continue cutting payouts next year, investors are becoming more selective about how they play the dividends theme.
“Bond yields are low because the outlook for growth is weak. A weak growth outlook means companies often miss on earnings, and when they miss on earnings, they often cut dividends,” said Daniel McCormack, strategist at Macquarie.
“The key is to look for companies that won’t miss on earnings ... In defensives, pharmaceuticals look very solid in terms of earnings and in the cyclical space miners and energy look very solid, but within that you have to make sure that there aren’t any company specific issues.”
Some 45 percent of European companies missed earnings expectations in the third quarter, according to Thomson Reuters Starmine data, including 60 percent of telecom firms.
One way to reduce the risk is to focus on companies with high free cash flow. Companies with healthy net operating profits left over after taxes and necessary investment have plenty of money to pass on to shareholders if they want to.
Filtering firms on this basis would mean focusing on consumer staples, tobacco companies, the IT sector, and healthcare, and steering clear of telecoms, according to asset managers Robeco.
“The main issue with telecoms is that most companies do generate reasonably okay free cashflows, but free cashflow year-on-year is declining because ... of the capital expenditure they have to make, or because pricing is under pressure,” said Mark Glazener, head of global equities at Robeco.
The average dividend per share paid by the STOXX Europe 600 telecoms sector will fall 12 percent next year, according to forecasts from data provider Markit, while basic resources could see a 4.8 percent reduction.
By contrast, Markit expects firms in the travel and leisure sector to hike dividends by 21 percent and automakers by 23 percent, the latter boosted by promises of higher payouts by BMW and Volkswagen.
BMW is also a top pick for Kames Capital, which in September launched the Global Equity Income Fund to tap the ‘sweet spot’ dividend yield of 4-7 percent, where, historically, realised payouts have matched forecast ones.
“Even in a sea of red you can find opportunities,” said Piers Hillier, head of overseas equities at Kames.
For investors who prefer not to pick individual companies, dividend futures offer exposure to future payouts from all firms in an index or a sector without actually holding the shares. Here demand is picking up for longer-dated contracts, which are cheaper and also offer more time for profits to recover.
“In the past people have played ... the short-term contracts that have the highest visibility, but now that you have a recession in Europe, the short term has become less attractive, because you are having all these cuts and there might be more,” said Kokou Agbo-Bloua, strategists at BNP Paribas. “So they are rolling, moving some of the short term into the longer term.”
Open contracts on EuroSTOXX 50 futures on the Eurex exchange have fallen in the past month on the 2012 and 2013, while rising by 9 percent for 2015 and 7 percent for 2016.
After two years of growth, dividends for 2012, most of which are already announced, are on track to fall by around 7 percent.
Futures for next year are pricing in a further 11 percent fall, offering modest upside potential if forecasts, for example, by French bank BNP Paribas for stable payouts prove accurate.
Further out, the market offers much larger opportunities. Futures are pricing in that dividends will drop by a fifth from current levels by 2016, while the average of analysts’ forecasts for individual euro zone companies actually points to dividend yields rising by then.
The difference is partly due to the supply and demand dynamics, where historically long-dated dividend futures have been undervalued due to structural over-supply from banks.
Relative confidence in the longer-term payouts is also backed by bottom-up analysts.
In the past 90 days, analysts have cut next year dividend expectations on STOXX 600 companies by 2.7 percent, where as forecasts for 2016 payouts are broadly flat, on average, according to Thomson Reuters StarMine SmartEstimates.
By then, SmartEstimates show the dividend yield on STOXX 600 rising to 4.1 percent from the current 3.8 percent - in stark contrast to the steep fall priced in by the futures market.
“If you look at the long end, it’s trading at a big discount and pricing in a lot more cuts than warranted,” Agbo-Bloua said. (Editing by Simon Jessop and Patrick Graham)