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Why this fund manager is worried about the sustainability of bank dividends

Australian Foundation Investment Co.Ltd. (ASX: AFI) is the veritable giant when it comes to the listed investment company (LIC) space on the ASX.

With a market capitalisation of $6.6 billion, Australian Foundation (AFIC) dwarfs nearly all other LICs with the exception of Argo Investments Limited (ASX: ARG) which boasts a market capitalisation of $5 billion.

AFIC’s long term CEO, Mr Ross Barker, is an investor with plenty of experience and when he shares his view on the market it’s worth listening.

In a recent article in the Australian Financial Review Mr Barker stated that it would be difficult for the major banks to maintain their dividends in light of the decision by the board of Australian and New Zealand Banking Group (ASX: ANZ) to cut its recent interim dividend from 86 cents per share (cps) to 80 cps.

Having earnt 132 cps (adjusted pro forma basis) for the half year, the pay-out ratio for ANZ’s dividend corresponded to 65%.

What could happen next?

The cut on ANZ’s dividend reduced the group’s pay-out ratio to a level significantly below that of its peers.

If this is a sign of things to come for the banking sector, then shareholders of the other three major banks could soon face the prospect of lower dividend payments as well.

Taking the most recent interim dividend payment from National Australia Bank Ltd. (ASX: NAB), NAB has a pay-out ratio of 82%. This is the highest of the “Big 4” and arguably it is the bank most likely to be forced to cut (based on an interim dividend of 99 cps each and interim diluted cash earnings per share (EPS) of 120.7 cps).

Westpac Banking Corp (ASX: WBC) has the next highest pay-out ratio at 79.5% (based on an interim dividend of 94 cps and interim cash EPS of 118.2 cps).

Rounding out the group is Commonwealth Bank of Australia (ASX: CBA) which had a pay-out ratio of 77.5%. As the lowest and arguably the most conservative of the group, CBA’s dividend sustainability could potentially be the safest (based on the last paid interim and final dividends of 198 cps and 222 cps respectively and a FY 2016 EPS result of 542 cps).

What should you do?

While bank shares have been a key sector for investors chasing fully franked dividend yields, as an investor in the share market it is important to be forward looking and not to focus on the past.

The popularity and pricing of bank shares is highly likely to wane if dividends are reduced, so a focus on downside risk appears necessary.

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This "dirt cheap" company. is growing like gangbusters, and trading on a fat dividend yield, FULLY FRANKED. With interest rates set to stay at these low levels for years to come, for income-hungry investors, including SMSFs, this ASX company could be the "Holy Grail" of dividend plays for 2016. Click here to gain access to this comprehensive FREE investment report, including the name of this fast growing ASX dividend share. No credit card required.

Motley Fool contributor Tim McArthur has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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