Some stocks are high yielding for obvious reasons but there are opportunities. Ian Butler, of the JPM UK Strategic Growth fund, explains how to separate the wheat from the chaff
Over the long term, the outperformance of high dividend-yielding stocks versus low-yielding stocks is significant. Since the start of 1986, the FTSE 350 Higher Yield Total Return index has outperformed the FTSE 350 Lower Yield Total Return index by around 1,000%.
However, while simply investing in high yielding stocks has been shown to outperform, in order to maximise returns, investors need to add an additional layer of analysis in an effort to avoid the yield traps within the high yielders: those stocks that are cheap for a reason.
These companies will typically have an optically high dividend yield because they are likely to cut it in the future and/or their poor share price performance will more than offset the high income element of their total return.
UK yield traps and how to avoid them
Our investment research team undertook some analysis into the cumulative total return performance of various segments of the UK market since 1955. As already discussed, it showed that high dividend yield stocks have outperformed low dividend stocks markedly over the period, as well as outperforming the FTSE 350xIT (a typical benchmark for UK income investors).
The UK income strategy line (see chart one below) shows the performance of high dividend yield stocks but with yield traps stripped out. This is achieved by removing the very worst stocks on both newsflow and dividend sustainability characteristics from the high dividend yielding stocks.
That group is made up of companies that have continually missed the market's expectations on earnings, whose share price performance has been very weak and which have poor dividend cover (on both earnings and cash flow measures). As the graph shows, this adds a significant further level of outperformance over simply investing in high yielding stocks.
It is also interesting to note that the yield traps in isolation have underperformed even the low dividend yield stocks within the market, which shows the importance of avoiding these names in order to maximise returns.
Chart one: Dividends yields 30/12/1994 to 31/6/2013
How it works
By way of an example, while the forecast dividend yield of 6% for Balfour Beatty appears attractive against the current 3.9% forward yield on the FTSE 350, it does not tell the whole story.
The company has been exposed to challenging market conditions in UK construction and European rail and has failed to meet market expectations on reported earnings - in fact, is has issued two profit warnings since November.
This has not only led to analysts having to downgrade their net profit estimates by more than 35% since then but it has also led to severe share price underperformance of more than 30% versus the FTSE 350 over both the last six and 12 months. While it has not yet cut its dividend, some market participants are now questioning its sustainability.
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