Lynn Strongin Dodds explains where the opportunities lie for dividend investing

Investing in high-paying dividend stocks has been a long-running theme but there are questions as to whether the wind has gone out of its sails. A prolonged rally combined with the recent steep fall in the total dividends paid by UK companies is making institutions think twice. The advantages haven’t disappeared
but investors are advised to take a harder look at the company fundamentals.

“It is a Hobson’s Choice that I espoused last year,” says Neuberger Berman head of investment strategy Alan Dorsey. In other words, do investors tilt an asset allocation toward lower-yielding sovereign or other similar bond assets in an improving economic environment with a potential for rising yields and falling bond prices, or take a risk on dividend-paying stocks and non-investment-grade bonds in an environment of improving credit quality?

“The downside was that these strategies would become more expensive, which is exactly what has happened,” says Dorsey. “We are in the middle stages of the investment phases which is why it is even more important to look at the underlying health of a company. The main benefits though haven’t changed in that equity income stocks are an important part of total returns for equities and remain compelling in today’s low interest rate environment against investment grade bonds.”

There is also evidence that higher yielding stocks outperform their lower dividend counterparts over the longer term. Take the elite group of companies in the US, dubbed the dividend aristocrats - an equal-weighted index of S&P 500 constituents which have followed a policy of increasing dividends every year for the last 23. They have boasted an average return of 2.23 per cent higher than the broader market with only 80 per cent of the volatility since the index was constructed in 1990.

Equity incomes stocks also tend to outshine their bond peers. For example, the average dividend paid by companies sitting on the MSCI Europe index is currently generating a 3.5 per cent yield versus a below inflation average of 2 per cent for investment grade European corporate bonds. In addition, research shows that there is more chance for capital appreciation as they have accounted for 42 per cent of the total annualised return of equity investments for the MSCI Europe since 1973.

The same scenario can be painted in the UK, although there are potential storm clouds brewing. UK income stocks are still generating a 3.7 per cent return but the most recent Dividend Monitor Report from Capita Registars showed a 25 per cent drop in payouts to £14.1 billion in the first quarter from £18.8 billion during the same period in 2012. It represented the steepest quarterly percentage decline since the middle of 2009 and is the lowest first-quarter figure for three years.

Capita noted that last year’s figures were skewed by one-off £4.4 billion special dividends from telecoms group Vodafone and Cairn Energy while a decision by HSBC to pay its first quarter dividend in December, not January, contributed to the reduction. The second quarter figures will also be impacted by surprise dividend cuts by insurance companies Aviva and RSA, the former Royal Sun Alliance. “Companies are cash generative and still reluctant to invest aggressively, but dividends must eventually fall into line with profit growth,” according to Capita.

As a result, it is unlikely that UK companies will match last year’s total payouts of £8.5 billion. However, market participants do not believe it should put investors off the strategy. As Fidelity Worldwide Investment head of European equities Paras Anand notes: “Often what happens is that people look at the type of stocks that had historic high yields and performed reasonably well in the past and there is a temptation to back out of the strategy because it is looking expensive. However, one of the biggest obligations that pension funds have is to meet the real liabilities of their pensioners and as a result they need to look at assets on a long-term basis. There is no better investment than good quality equity because it will act as a hedge and grow ahead of inflation.”

As an example, Anand points to Unilever, where shareholders have enjoyed a 9.5 per cent annualised growth rate while keeping three times ahead of the rate of inflation. In 1990, the consumer giant distributed a 12p a share gross dividend which has skyrocketed by 700 per cent to 87.6p in 23 years. Less dramatic but equally as noteworthy is HSBC’s share, which has increased to 39p from 6.9p over the same time period. Despite the dividend cut in 2009 the growth rate has been fourfold and it has kept ahead of inflation by 2-2.5 times.

Traditionally, income investing was broadly divided into three categories with the first one being funds that specifically target a high income followed by those that look in equal measure for growth as well as the need for an above average income. Last but not least is the group that adopts a total return approach. Philosophies are changing though and many are not only mixing approaches but also casting their nets wider in order to invest in some of the world’s fastest growing countries in order to significantly enhance the yield opportunity.

Momentum Global Investment Management investment director Glyn Owen believes it is a mistake to just target companies with the highest yields when constructing a portfolio. “This could be a potentially dangerous strategy in that you could be drawn into buying value traps and broken business models. Investing for income should not be the only criteria. You need to look for companies that have the potential for growth. This includes those with strong management, balance sheets, low debt to asset, global franchises and sustainable businesses.”

Kleinwort Benson Investors head of strategy development — dividend plus strategies David Hogarty adds: “People often see income as a separate strategy but I think there are three key ingredients – as well as the income you need dividend growth, and capital appreciation. You need to get all three right. It is also important to not just focus on the staid and well-established companies in developed markets which is why we run an all-cap, all-industry fund as well as an emerging market fund. There are around 821 stocks in the MSCI Emerging Market index and the vast majority pay dividend yields that are higher than in North America. Also, in regions where the accounting practices aren’t as strong as in the West, dividend payments are a straightforward way for companies to show their earnings are real.”

Momentum is also a proponent of emerging markets. “They have not really moved while developed markets are up 15 per cent,” says Owen. “Also, companies such as Aviva and RSA who cut their dividends have had their share price slaughtered by the market. These differences are presenting interesting opportunities especially in Asian income funds although you have to do your homework to find the quality companies. We are avoiding Latin America because they are heavily dependent on the fluctuations of the commodity cycle.”

As for the developed markets, there are still prospects to be uncovered in many of the stalwart sectors such as low cyclical, consumer oriented, utilities, tobacco, and pharmaceutical that comprise the bulk of the equity dividend funds. “Equity investment has always been about strong companies paying healthy dividends,” says consultancy Hymans Robertson partner John Walbaum. “What we are increasingly seeing today are investors balancing portfolios between steady dividend growing companies and the more speculative parts of the market. Investors should be aware that many of these stocks can be less exciting in rising markets but will offer downside protection when prices fall.”

Whichever strategy an investor opts for, Anand believes that: “They need to ascertain, especially on a long-term basis, which businesses have the pricing power to fund the operations and the franchise that will remain robust and strong. Also, it is important to analyse the industries that they operate in and whether there will be any changes that will impact their prosperity.”

Lynn Strongin Dodds is a freelance journalist

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