Corporate profitability should be returning to the market as more companies are reporting figures ahead of market expectations but economic shocks mean a holding in higher-yielding stocks remains key
Theory suggests that a rational investor should not care about income. Instead, he should be concentrating on the total return he generates from his investments. Assuming that he buys his securities and holds them for a substantial period of time, he should not be too concerned about the gyrations of the market towards either high-yielding or low-yielding securities.
However, fewer and fewer people make active investment decisions over such a long timescale which means that we do have to be concerned about the market's phases and which types of stocks are in favour, and why.
As the technology bubble inflated through the late 1990s, the attractions of dividends diminished sharply. Even supposedly rational individuals were caught up in the 'greed' phase of the bubble's formation and preferred to chase the large capital gains that were available from high growth tech, media and telecoms stocks. Of course, most of these companies were over-investing and incurring sizeable losses. Paying a dividend was little more than a future aspiration to them.
As we all know, over the past three years, the picture changed markedly as the greed turned to fear. Investors had their fingers burned by the severe bear market when the tech bubble burst. With stock market volatility scaling unprecedented heights, those who have remained loyal to equities have been searching for a higher degree of certainty in their investments.
This relative certainty can be provided by the dividend payments made by companies to their shareholders. This means while an investor sees the paper value of his shareholding rise and fall, the cash passing across his palm in the form of dividends gives him a feeling of comfort and financial security. It does so because in normal circumstances, the level of the dividend is fairly predictable and normally rises a little each year.
My overriding view is that markets are likely to rise from here but by no means in an orderly manner. My principal reason for arriving at this conclusion is that I do not believe the UK equity market is expensive at an aggregate level. I believe when the yield on the FTSE All-Share index and the 10-year gilt equalised at around 3.5% towards the end of the first quarter of this year, that marked a watershed for the market. It forced investors to look more rationally at valuations and created what I believe will be a strong base area of support for the equity market generally.
Despite the recent rally in equity markets, there remains a high degree of uncertainty and scepticism over the basis of this stock market rebound. In particular, nervous investors are worried about the strength of the UK economy and the degree of recovery to be expected in corporate earnings. So, should we be concerned about the sustainability of the income generated by companies' dividend payments?
Firstly, in economic terms, the UK is relatively healthy, especially when compared with other major economies such as Germany and Japan. Interest rates are at multi-generation lows, the economy sits at close to full employment and consumption has held up for longer than can have been reasonably expected. However, corporate investment has been sluggish for some time as the slowdown in oversees economies has clouded the sales outlook and diminished management confidence about the future.
The outlook for the corporate sector is broadly encouraging. Dividends are intrinsically linked to earnings and the latest reporting season has shown a gradual improvement in the performance of UK-listed companies. However, there have been some disappointments along the way. The financial sector provides a good example of this mixed picture. There have been some alarming headlines from some companies, such as Prudential, Lloyds TSB, Aviva and Britannic, where caution over their future dividend policy has received a fierce reaction from the market.
Despite these shocks, recent results in broad terms have been no worse than expected and, in some cases, have exceeded expectations. In fact, dividend growth for the sector as a whole has been good, indicating that the banks' approach to monitoring and controlling credit risk has been more effective than during the previous economic cycle.
In the broader market, figures produced monthly by Deutsche Bank clearly illustrate that more companies are reporting figures ahead of the markets expectations than those who are disappointing. The forward-looking aspect of the data, which looks to the coming year's trading has not yet turned positive in aggregate, but has steadily improved over the last year. It is not clear what specific catalyst will be required to encourage greater levels of investment but improved profitability and a clearer outlook can only be helpful in this regard
I believe current forecasts for dividend growth for the market as a whole are still a little optimistic. Evidence suggests that companies will increase their dividend cover by holding back on dividend growth as earnings recover. Another barrier to dividend growth this year is the fact that a number of the UK's largest companies set their dividends in US dollars, including BP and HSBC. With the dollar down by well over 10% against sterling in the past year, UK investors' dividend income from stocks such as these may not achieve much growth.
The upshot is that some companies will struggle to hold or grow their dividend in the coming year. In the past year we have seen dividend cuts from a diverse range of companies such as Scottish Power, Royal & Sun Alliance, FKI, Abbey National and ICI, while a lack of visibility on the subject has hit the share prices of Prudential and Lloyds TSB. So while I am optimistic about the trend in corporate profits and the overall direction of the market, I believe there will be setbacks along the way in the form of profits warnings and the associated dividend risk.
So, how reliable is dividend yield as a predictor of performance? Firstly I would warn of the dangers of relying on one measure or indicator for all of your investment decisions. If you had bought the five highest-yielding shares one year ago, you would have been buying many of the companies who have subsequently cut their dividends and seen their share prices fall substantially. However, as you can see from the chart above, higher yielding FTSE 350 stocks have enjoyed substantial outperformance of the overall index since March 2000 when the tech bubble burst. But it is also obvious from the chart that simply investing in high-yield stocks in the last five years would have been anything but boring. The simple answer to the question of reliability though is 'sometimes'. As an investor it is important to assess the market environment and the economic backdrop before deciding on whether the stability of a strong income flow will be an attractive factor which will encourage other investors to buy a company's securities.
I am becoming increasingly confident we are on the brink of a cyclical recovery in corporate profitability and that this will provide fuel for the stock market to continue its recent rally. In this environment, I am paying less regard to income derived from companies' dividends than I have for the last three years when selecting companies in which to invest. However, there are likely to be both economic and corporate shocks in the course of the next year which will affect confidence and cause market setbacks along the way. For this reason, I remain in favour of keeping a slight bias in favour of higher-yielding stocks.
Forecasts for dividend growth in the market are optimistic.
Dividends from many companies have dropped because of the weaker dollar.
Markets are likely to rise but not in an orderly manner.
Yield is not a good predictor of performance and is less relevant now than it has been.
Yield remains an important aspect for investors with further economic and corporate shocks likely.
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