On the lookout for dividends

Dividends play a crucial role in making meaningful gains from shares. Barclays Global Investors' annual Equity Gilt Study of investment returns since 1899 proves that conclusively.

If you had invested £100 in shares back then, it would have been worth £170, after allowing for inflation, by the end of 2009. Had you reinvested your dividends, it would be worth 130 times that amount, at £22,150.

Of course, a century is far longer than any investor's time horizon, but dividends also deliver over shorter periods. Ted Scott, director of UK strategy at F&C Management, calculates that dividends account for around 60% of investment returns.

That sounds reasonable. A yield of, say, 3.5% - roughly the current level for the UK market - locks in a reasonable return, even without price appreciation.

This makes the fall in dividends in recent years all the more painful. Last year's 20% decline in UK payouts was, says Scott, the worst since 1993, excluding 1997 when then-chancellor Gordon Brown imposed his dividend tax.

On top of this, the share buy-backs and special dividends that were commonplace among large companies and buoyed investors' income in recent years has all but disappeared.

Sadly, the dividend cuts are not over. Richard Hughes, manager of the M&G Dividend Fund, points out that many companies, such as Aviva and BT, have maintained their payouts, but he warns of cuts to come.

And dividend growth is likely to remain low for some time. Banks once provided a large proportion of dividend income in the UK, but Lloyds Banking Group and Royal Bank of Scotland, which were both rescued by the government, will not be paying anything for some time.

HSBC and Barclays have cut their payouts sharply and will focus on rebuilding their capital bases rather than paying dividends.

There is also doubt about the sustainability of the payouts from two big oil companies, Royal Dutch Shell and BP, which account for a quarter of the market's dividends.

Invesco Perpetual's equity income investment guru Neil Woodford has sold his holdings in these companies because he doubts they will be able to sustain the huge investment needed to find new oil reserves and fund their generous payouts.

Yet Woodford is still relatively sanguine about the prospects for dividends. "The dividend decision is a very profound one because it ultimately involves writing a cheque to shareholders," he says.

"Good boards look at dividends as an important signal to the underlying corporate health of the business."

He adds that there is a unique combination of stocks that have underperformed but are best placed to deliver dividend growth. "[Because of this] there is no problem on either yield or dividend growth from my portfolios", he explains.

That includes pharmaceutical and tobacco companies, which represent a very large proportion of Woodford's income and high income funds.

Investing in companies that can grow their dividends, rather than just deliver a high yield, is key to securing good returns over the longer term.

That is partly because a high yield can indicate that the market is worried about a dividend cut and, as the banking collapse clearly showed, such fears are often realised.

But it is also because the capacity to grow dividends is one of the clearest signs that the company's business is successful and expanding, and that the shares are due a re-rating.

Scott points to British American Tobacco as a good example of this. In 2000, it paid a dividend for the year of 29p and its shares had a generous 10% yield.

In 2009, it paid almost that - 27.9p - in the interim dividend alone and the full-year payout is likely to be at least three times the 2000 total.

For the next nine years, BAT outperformed the stockmarket tenfold, although it lagged last year as cyclical shares became popular, meaning that once again it has a better yield than the market as a whole.

Other high-yielding sectors, such as telecoms and pharmaceuticals, also lagged the market last year, but Scott thinks they now offer value. GlaxoSmithKline, National Grid and Vodafone are all expected to increase their payouts by at least 7%.

M&G's Hughes points out that 20 FTSE 100 companies grew dividends by at least 10% last year, and some, such as WM Morrison Supermarkets and Reckitt Benckiser, raised full-year payouts by more than 30%.

But many companies will find it difficult to increase their earnings or dividends. Consumer businesses such as retailers are likely to suffer as consumers focus on paying off debt, while banks have to rebuild their capital.

That has prompted some fund managers to predict a return to the Nifty 50 type of market last seen in the 1960s, where a few global companies provided most of the market's growth.

Bill Mott, manager of the PSigma Income Fund, says: "Assuming a very low-growth environment in the UK and an anaemic recovery elsewhere, those UK companies that can deliver growth far in excess of the average will be re-rated in a return to the Nifty 50 style of the 1960s and 1970s, when the top 50 most popular large cap stocks led the market and rewarded a 'buy and hold' strategy.

"These companies will be able to deliver this superior growth because of their high exposure to faster-growing areas of the world, the industry in which they operate, or their superior technology or management ability."
Mott is rebalancing his high-yield portfolio with companies he believes will deliver superior growth, including Tesco, WM Morrison, Reckitt Benckiser, Inmarsat, Healthcare Locums, Serco, Xchanging, Compass and Arm Holdings.

Whether investors look overseas or at home, it is possible to find investment opportunities that offer a decent income, even in these recessionary times.

Go global for a wider choice

The concentration of income streams in just a few UK companies means it could be worthwhile looking overseas. Mott has already allocated 9% of his portfolio to international companies such as Deutsche Telekom and US drugs group Pfizer.

Raj Shant, manager of Newton European Higher Income, points out that while the UK has just 100 companies with yields of more than 3% and market values of more than €300 million (£264 million), in continental Europe there are almost 400.

Shant adds that while two-thirds of UK dividends come from just two sectors - resources and banks - in Europe, no single sector contributes more than a fifth of dividend income and the overall market yield is more evenly spread between industries.

Sectors such as pharmaceuticals and utilities also contribute a good proportion of total income.

While European companies also cut their dividends last year by a similar proportion to UK companies, they should start to grow this year. Shant expects a rise of around 10% across Europe.

However, Europe is not the only place to look for equity income. Stuart Rhodes, manager of the M&G Global Dividend Fund, points out that only three UK companies, Tesco, Halma and PZ Cussons, have a 25-year record of increasing dividends.

In the US, there are 15 times as many, including Coca-Cola and Johnson & Johnson.

Rhodes is enthusiastic about some markets that are more associated with growth than they are income. He says companies in Australia and Brazil are particularly interesting.

"Cochlear, an Australian manufacturer of leading-edge hearing aids, and AES Tiet, a Brazilian hydroelectric power generator, are companies with excellent fundamentals that also benefit from a dividend-friendly environment."

This article was originally published in Money Observer - Moneywise's sister publication - in March 2010