A low inflation, low interest rate environment brings the importance of income to the fore. Stocks with high yields should give investors good returns when there is an upturn in the market
One way or another the value of income and the role of dividends in the generation of investment returns are becoming central issues in the current debate about investment strategies.
This is a welcome return to old habits and a useful starting point to assessing ways of profiting from today's depressed stock market.
It is worth putting the debate in its historical context. Investing in equities was traditionally regarded as an exercise involving an element of risk. Hence until 1959 equities offered a higher yield than gilts, by way of compensation. From that time until the present, even during the deep bear market of 1973/74, gilts yielded more than equities, with the gap reaching an extreme of 9.3% at the end of 1981. Since then it has significantly narrowed, so that the FTSE All Share Index currently yields 3.9%, only 0.25% less than the 10-year benchmark gilt. This both reflects the superlative performance of bonds in recent years and a widespread feeling that many companies may be forced to rethink their dividend policies in 2003. Is the latter assumption at all realistic?
We believe that the market is being unduly pessimistic and that modest dividend growth is set to continue. In the UK, in contrast to continental Europe, the recent company reporting season has been relatively reassuring, at least as far as dividends are concerned. While there have been some actual reductions and much debate over how much longer high-yielding troubled stocks like Reuters and Rolls Royce, can sustain present payment, there was a modest increase in overall payout levels.
To put a more positive spin on the matter, some companies even increased their distributions by double-digit percentages. Banks, notably Barclays and Northern Rock, led the way, but there were also healthy increases from such diverse stocks as British American Tobacco, Persimmon and Unilever. Given that dividends are paid out of taxed profits, a rising dividend sends a powerful message of management confidence about future prospects. As such, it is tempting to view such stocks as possible investment candidates, especially if other valuation measurements stack up.
By contrast, dividend cuts among continental companies were far more frequent, reflecting the much tougher operating conditions they are facing.
A key issue to consider is that for most of the 20th century is that reinvested dividends accounted for over 60% of total returns from UK equities. Of course, the great exception was the period 1980-1999, which saw an exceptional level of capital appreciation averaging more than 15% per annum in nominal terms over the period.
That high level of returns inevitably coloured future expectations. Only now, after three consecutive years of decline, are there signs that investors are prepared to moderate their expectations.
To this end, a typical actuarial projection for UK equity returns over the coming decade is approximately 5%-6% per annum after adjusting for inflation. This figure is remarkably close to the rate of return from UK equities produced over the past century. More significantly the contributions of capital growth and dividend income to future total returns is likely to be much closer to the 50-50 split which prevailed between 1955 and 1980 than the 72% average contribution from capital growth which was the rule in the 1980-2000 period.
With these modest targets in view, the case for investing in a well-diversified equity income fund in a broad spread of good quality high yielding shares seems compelling. There are two key reasons for this view: first, on the basis that this represents the relatively defensive, low risk route to equity investment.
After a deep and prolonged bear market, which has badly undermined investor confidence, such a message may ring hollow in the ears of savers who probably feel that equities are all risk and no reward. But such an opinion typifies the low point of any market cycle when good value is abundant but where buyers have lost faith in the possibility of any improvement.
The FTSE 350 Index has outperformed the FTSE All-Share Index during the major part of the bear market and should sustain this relative advantage should difficult conditions persist. However, high yielding shares are also well placed to make progress in the event of any market upturn.
Second, on income grounds. We anticipate a continuation of the current low inflation/low interest rate environment. Base rates may even decline further, prompting banks to cut returns on cash deposit accounts even more.
In these circumstances, the search for income becomes ever more urgent. The current yield of 5.1% on the FTSE 350 Higher Yield Index compares favourably with base rates of 3.75% and the yield of 4.15% on ten-year gilts. Over half the FTSE 100 Index constituents now yield more than base rates. Many financially secure companies with comparatively solid prospects offer yields in excess of 10-year gilts.
Prominent examples of these, all blue chip names from a variety of different sectors, include Barclays (5.3%), British American Tobacco (5.8%), Land Securities (5.6%), Pearson (4.8%) and Sainsburys (6.8%).
Retail investors do not need to make a black and white choice. Another key lesson arising from market adversity is the virtue of a diversified portfolio. Few investors would risk jettisoning the bonds which have served them so well over the past three years. But including an equity income weighting hardly seems a risky proposition and offers a good chance of rising income levels.
View that companies will be forced to rethink their dividend policies is unduly pessimistic.
Low interest rate and inflation environment makes the search for income more urgent.
High-yielding shares are well-placed to benefit from any upturn in the market.
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