The jury can't reach a verdict on income stocks. While study after study shows that shares trading cheaply compared to earnings or book value beat the market if held for long enough, studies on high-yielding stocks are more equivocal.
Although companies paying generous dividends have beaten the market handsomely over the past decade, interest rates have been at record lows and the recent popularity of income shares may say more about the paucity of income offered by the alternatives, cash and bonds, than the intrinsic value of dividend-paying companies and their potential to beat the market in future.
In a study of the US market between 1952 and 2010, Professor Aswath Damodaran established that shares with high dividend yields beat shares with low dividend yields, but only conclusively between 2001 and 2010 when investors may have been seeking safety in income shares during difficult markets. In previous decades high yielders equalled low yielders, or did worse.
Since dividends attract taxation, often at a higher rate than capital gains, in theory the money's better off invested in a growing company unless you need the cash, in which case you could just sell shares.
So why do investors like income stocks?
The most compelling reasons may have more to do with investor behaviour than the intrinsic value of income shares.
Selling shares, for example to fund retirement, means liquidating capital, which may not come easily to an investor who has spent most of their life building that capital, even more so if a desultory market means the investor feels like they are getting a bad price.
Selling shares means deciding which shares to sell, which is difficult, while collecting dividends, effectively allowing companies to liquidate part of your investment for you, need not even involve cashing a cheque these days.
For investors still accumulating capital there's also a powerful behavioural incentive: a regular dividend gives them confidence to hold on to shares for the long term, irrespective of what's happening to the share price. If, as is often the case, investors are their own worst enemies, selling when prices are low and buying when they are high, the dividend is something else to focus on than the treacherous share price.
The dividend is a fact, which makes deciding when to buy and when to sell shares less arbitrary than focusing on earnings or book value, both of which are accounting opinions and often subject to massive fluctuations from year to year. It's easier to appraise the dividend than a company's value, which should make the task of deciding which companies to buy, and which companies to sell, simpler.
And despite the inconclusive evidence on the performance of income stocks, they can be systematically undervalued. Income portfolios can beat the market average over the long term, but probably not if we just pick the companies with the highest yields.
The problem with dividends is they can be cut, generally when a company can no longer afford them.
A chart from investment bank Société Générale shows the difference between forecast yields and realised yields for large companies worldwide. When dividend yields are more than 5% or 6% the dividends subsequently paid begin to diverge markedly.
Companies with very high dividend yields are often distressed, meaning they are unlikely to maintain the dividend. The share price, which is the denominator of the dividend yield calculation, falls as income investors anticipate a cut, flattering the dividend.
Falling share prices and cut dividends are a bad combination, so, as income investors have always known, dividend cuts must be avoided.
Buying shares that pay a reliable dividend of say 4% to 6% currently, as opposed to high-yielding shares paying more than 6%, is more likely to profit investors. If there is value in income investing, it's most likely to be found in the vast middle income ranks.
The 10 PICKS
From the top of the table, Inmarsat, with a dividend yield of 5.5%, is evidence income shares need not be boring.
As the International Maritime Organisation it operated the first global mobile satellite communications system and today the company, which went private and then floated in 2005, owns and operates three constellations of 11 orbiting satellites. The satellites allow mariners, pilots, the media, aid agencies, soldiers and corporate clients to make calls and connect to the internet.
In its 2011 annual report Inmarsat reaffirmed its commitment to pay increasing dividends by raising the dividend 10% and saying it expected the same level of increase in 2012. It's also returning cash to investors through a share buy-back scheme.
Textile rental and laundry service Berendsen, formerly Davis Service, also increased its dividend by 10% last year in accordance with a progressive dividend policy that has produced modest but inflation busting compound annual per-share dividend growth of 5% over the past five years.
A market leader in Denmark, Sweden and Norway and operating throughout northern Europe, in the UK it trades as Sunlight and supplies the healthcare industry. The company believes a reorganisation last year will deliver a modest improvement in performance this year.
Balfour Beatty boasts 12 years of dividend growth since it emerged as an independent company from the closure of BICC, its former parent of 40 years, but the construction company has a much longer history.
Its first project was Dunfermline's tramway over a hundred years ago. Although Balfour Beatty has diversified a long way since then, the UK is still its main market, followed by the US, where the economies are weak and public spending constrained, so the company is understandably cautious about the future and concentrating its efforts on the private sector and international markets.
The smallest company in the table, SpaceandPeople, only just sneaks in because it paid its first dividend in 2005, but it has grown the dividend at a compound annual rate of over 14% a year over the last five years and currently yields 4.6%. It sells and manages promotional space in shopping centres, theme parks, garden centres and airports on behalf of venues in the UK and Germany.
Informa wobbled in 2008 when the academic publisher, which is better known by brands like Datamonitor, Taylor & Francis and Routledge, responded to economic uncertainty by cutting the dividend.
By eliminating less profitable publications, conferences and training courses, and making acquisitions - the latest being Fertecon, a provider of fertiliser commodities pricing data - it has since rebounded strongly, achieving compound growth over the five-year period including 2008 of 10%. Since 2008, debt has fallen and profitability sustained helping to secure the dividend.
Including an established high street retailer, especially one that sells books, in a list of stable boring companies that should continue paying good dividends seems reckless in the current economic circumstances but WH Smith's record commands attention.
It slipped up in 2007 when the dividend fell 23%, and it too has recovered strongly while profitability has improved, and the company has remained relatively unindebted (although it has considerable lease and pension obligations). Since chief executive Kate Swann joined the board in 2003 the stationer has enjoyed an unlikely renaissance driven by growth in its travel store portfolio.
Churchill China has not raised its dividend in four years as competition and economic stagnation held back profits, but profitability is moving up again and it remains financially strong.
Since the company intends to return to a progressive dividend policy and it has a coherent strategy to supply pubs, hospitals and cruise lines with durable tableware made in Britain, while scaling back its less profitable retail business, Churchill China enters the table with compound annual per-share dividend growth of 3.1% and a 4.5% yield.
Greene King may well be a customer of Churchill China. The pub chain and brewer, which as well as its eponymous IPA brews Old Speckled Hen, Belhaven Best and Abbot Ale, has raised the dividend every year since at least 1992.
Like many of the selections, at Greene King paying increasing dividends isn't just a habit, it's part of its long-term financial strategy, made possible by the stable revenues of pubs and expansion from its East Anglian home, with the acquisition of Cloverleaf Restaurants in the North and Midlands, and Realpubs, trading in London.
If you are an income investor, next time you see men distributing cones along the fast lane, think before you curse. While Balfour Beatty is building infrastructure, WS Atkins' engineers are designing it and managing large construction projects.
Like Balfour Beatty its main market is the UK, in fact the two companies run a joint-venture partnership operating and maintaining the M25. And like Balfour Beatty it's aiming to secure future dividends through diversification and geographic expansion.
Rounding up the top 10 yielders is Alternative Networks, which has only paid a dividend for seven years but raised it by more than any of the others over the last five, from 3.3p a share to 11p a share, a compound annual growth rate of 40%.
The company is a telecommunications consultancy. In 2011, Alternative Networks increased the dividend 10% over the total dividend the previous year including a special dividend. It's targeting 10% dividend increases in 2012, 2013, and 2014.
Top 10 companies with above-average yields
|RANK||INDUSTRY||CAP £M||F-SCORE||YIELD %||CAGR %|
Source: Stockopedia, 26 June 2012
This article was written for our sister publication Money Observer.