The 3.5% yield on the UK stock market is among the most generous in the world. By comparison, the...
The 3.5% yield on the UK stock market is among the most generous in the world. By comparison, the US equity market yields only 1.8%, with some 30% of S&P Composite Index constituents not even paying dividends. US firms paying dividends have outperformed the market over the past two years.
Only smaller developed markets, such as Australia and Belgium, or emerging markets, offer higher levels of income. This feature has been well recognised by UK investors, as the deep-rooted popularity of equity income funds attests.
Contrarians might suggest that, following a prolonged period of outperformance by equity income funds, their constituents are fully valued and low-yielding growth funds are poised to outperform once a more positive environment returns. This might be the case over short periods of time but we believe that even after the lacklustre returns of the past three years, most investors still prefer to take a long-term view on equities. Furthermore, the cautious mood of retail investors is hardly conducive to taking an aggressive line on high-beta equities.
Buying a well diversified equity income fund represents something of an each-way bet ' exposure to a stock market recovery, along with an element of protection if difficult market conditions persist. Equity income funds often perform well during bull markets, as was the case in the 1980s.
Buying a growing stream of income with an above-average starting yield represents an effective strategy of accessing value in the stock market. One of the key lessons arising from the prolonged equity bear market is the importance of dividends as a measure of value, which cannot readily be distorted by clever accounting. This lesson is unlikely to be forgotten, especially if the coming decade is one of low levels of inflation and interest rates, coupled with steady economic growth.
The implications of this are that total inflation-adjusted returns from equities are forecast to be closer to 7% a year than the 15%-plus level enjoyed in the 1980s and 1990s. This figure, which is only slightly above the expected return from bonds, would be achieved through a more balanced contribution from capital gains and dividend income than in the 1990s.
UK investors are fortunate that there is an abundance of good quality income stocks. At the end of September half the FTSE 100 constituents yielded more than base rates (4%).
But there are some risks in this approach. Many firms are struggling to maintain profitability at present. Dividend cuts are not rare ' firms have little choice if maintaining dividend payment materially damages their financial health. But, given the wide choice of high yield stocks in the market, income fund managers can afford to take a selective view, avoiding shares in firms where there is a risk of a dividend cuts and focusing on those with a stronger financial position and higher dividend cover.
Retail investors do not need to make a black and white choice. Another lesson arising from market adversity is the virtue of a diversified portfolio. Few investors would risk jettisoning the bonds that have served them so well over the past three years.
Defensive qualities in high yielding equities.
Dividend income to total returns a plus.
High yielding shares in abundance in UK.
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