Tony Stenning looks at why retirees should still be looking to include equities in their retirement planning strategies.
Stock markets this year may well provide a challenge for equity investors as growth opportunities, amid the threat of recession in both the UK and Europe, become harder to spot.
Most economists and analysts expect company earnings to flatline this year, requiring investors to seek those sectors or situations which offer the best value.
Few long-term investors will now look at equities purely from a perspective of seeking capital growth, unless they feel sure that either the underlying earnings can grow, or the share price can evolve due to external pressures such as new discoveries or M&A.
This has made the search for equity income more important, since dividends can offer a cushion for those investors who wish to retain exposure to stocks, but don't want to have to rely on capital growth alone.
It is not just a case of looking for dividends in isolation. The need for worthwhile levels of income has also put higher emphasis on dividend yields. This has become vital given that bond yields for the few issuers of government debt that retain the coveted AAA credit rating, such as the UK, have hit new historic lows.
Dividends and growth
Let's break this argument down into two parts: the search for dividends and the search for yields. The best dividend payers are those companies that have sufficient cash flow and sustainable market shares to be able to be generous with their payouts.
You might think that in a recessionary environment with the emphasis on debt reduction and national austerity measures, such companies would be hard to find. After all, companies can only generate cashflow through net profits, and most people expect earnings to be static this year.
The good news is that the UK equity market is rich with high cashflow producers, with sustainable market shares - and ‘rich' is an appropriate word to use. British firms are sitting on about £180bn of cash, which is being generated at the rate of about £15bn a year.
The cash pile is now worth about 10% of the stock market capitalisation of British listed companies. Part of the reason for this is that the UK market is not a pure play on the domestic economy, which contracted in the fourth quarter of 2011 and may well contract again in the first quarter of 2012.
This is because the UK's largest firms generate only about one-fifth of their revenue at home. About four-fifths comes from overseas, including a growing proportion from high-growth emerging markets.
Investors, therefore, are essentially tapping into a global export market where the issue for economies such as China is not in combatting recession, but in trying to prevent over-heating.
So what to do with all this cash? Companies are reluctant to splash out on M&A or engage in expensive capital expenditure when expansion may not be matched with a reciprocal return on investment through higher demand for their products.
Instead, they are using the money to fund higher dividends. According to recent research, total payouts by UK companies rose by almost 20% to £67.8bn last year, with underlying dividend growth amounting to 12.8%.
The sum was boosted by £2.9bn of special dividends by companies such as Vodafone making one-off payments following specific cash-generative events (in its case, receiving its first dividend from US phone giant Verizon since 2005).
Turning to dividend yields, payout ratios were estimated to be 4% for UK firms in 2011, above the 2.5% earned in the US and Japan, according to research by Société Générale. These yields are forecast to rise this year to an average of 4.3% for the UK market in 2012, compared to 2.7% for the US and Japan.
At a sectoral level, industries that make excellent dividend plays include telecoms, utilities and healthcare, as all are highly cash generative and tightly regulated, making it harder for companies to engage in costly expansion.
Yields for 2011 are forecast to be as much as 6.4% for telecoms -companies, 5.4% for utilities, and 4.5% for healthcare providers, all above their American or Japanese counterparts. For 2012, they are forecast to be 6.9% for telecoms, 5.8% for utilities and 4.7% for healthcare groups.
These payout ratios become particularly attractive when you consider the comparable yields available in bond markets.
While some eurozone debt carries high yields on new issues, such as levels above 5% offered on new Italian debt, the attendant risk must also be considered. Of the ‘safe haven' bonds, UK ten-year gilts currently yield 1.9%, while their equivalent benchmark US Treasuries and German Bunds offer 1.8%.
One of the reasons that yields are so high is due to the battering that stocks have received in recent years. The relative cheapness of UK equities can be seen in price/earnings ratios. The UK market is forecast to trade on a p/e multiple of 9.6 times earnings in 2012, compared to 12.6x for the US and 11.7x for Japan, according to Société Générale.
It is not just about dividends and yields. Low stock prices also make it possible for equity income managers to pursue capital appreciation as well as dividend growth, using the ‘barbell' strategy.
This picks high-growth companies with the potential to see rises in their share prices at one end of the barbell, and high dividend growth companies at the other.
The strategy gives investors the best of both worlds, while mitigating the risk that would accrue from purely pursuing share price rises that may not transpire in a recession.
All in all, the rising level of dividends, together with the relative cheapness of UK equities and low yields available elsewhere, looks set to increase the attraction of income funds to portfolios this year.
Indeed, it may turn out to be one of the few growth stories, and one that is put at the top of many investors' strategies in what may be a challenging 2012.
Tony Stenning is head of UK retail at BlackRock
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