Generating an income from investments is one of the key reasons why people put money into the markets. The average yield on FTSE 100 stocks at present is 3.8% which is significantly higher than both the current rate of inflation (3.1%) and the top rate of interest on cash savings accounts (1.3%).

As Alex Crooke, head of global equity income at asset manager Janus Henderson, observes: ‘The absolute level of dividend yields remains very attractive to investors when compared to other asset classes.’

In this article we look at the 40-plus shares in the FTSE 350 index which offer a prospective yield of 5% or more, as well as a range of
funds, investment trusts and exchange-traded funds doing
the same.

We also examine in more detail how you can find, protect and grow the income from your investments over time.

Elsewhere in this week’s issue of Shares, we look at small cap companies which also have 5%+ dividend yields and discuss the pros and cons of special dividends.

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HOW TO FIND INCOME

The income from shares and funds comes in the form of a dividend. This payment is typically made in cash twice a year, although sometimes more frequently.

For individual company shares, dividends are paid from the cash flow left over after the business has met all its other financial obligations. Funds pay dividends generated by the income from their underlying holdings (which is likely to contain dividend-paying companies).

Not all shares and funds pay a dividend, unlike other asset classes such as bonds. Individual companies can cut or cancel a dividend entirely at their management’s discretion. Some companies have never paid a dividend as they may prefer to recycle all their cash generation back in to the business to fund growth – or they have negative cash flow, such as some early stage miners, drug firms or tech companies.

The decision to start or resume paying a dividend can often act as a positive catalyst for a share price. Paying a dividend puts a stock on the radar of fund managers and other investors who ignore non-dividend payers, for example.

Companies who restart dividends after a period of not paying out cash to investors can be viewed as businesses who have fixed a problem which previously led to the payout’s suspension.

A company considering a maiden dividend suggests it has reached a point in its development where it is financially comfortable and capable of sustaining dividend payments.

Income is usually measured by way of yield. For equities, this is calculated by dividing either the forecast or historic annual dividend per share by the share price and multiplying by 100.

For example, oil major Royal Dutch Shell (RDSB) trades at £25.63 and is forecast to pay 138.5p per share in 2018. This translates into a dividend yield of 5.4%.

HOW TO BENCHMARK YOUR INCOME

Measuring the generosity of yield offered by a prospective investment requires benchmarks. There are several you can employ.

Investing in shares is riskier than holding cash on deposit so you want to generate a higher return than the best rates available on cash savings which are around 1.3%, unless you are prepared to tie up your cash for several years.

You also need to beat the current rate of UK inflation which is 3.1%. For a dividend yield to be truly generous it should be higher than approximate 4% average for the FTSE All-Share index.

Just watch out for overly-generous yields, such as anything above 7%. Occasionally a company’s business model can support this level of dividend return. However, in most cases a high yield is the result of a falling share price – the market’s way of saying that it doesn’t believe current earnings (and therefore dividend) forecasts.

 

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TOP YIELDING FTSE 350 STOCKS – BEHIND THE NUMBERS

The accompanying table shows 43 companies in the FTSE 350 index which have a prospective dividend yield in excess of 5%. This is based on the share price at the time of writing and the dividend payout forecast by analysts for the latest financial year still to be reported.

Some of these names could represent genuine opportunities for income-hungry investors.

UK bank Lloyds (LLOY) used to pay very generous dividends until the financial crisis hit. It stopped paying for a while and resumed dividends in 2015. The payments are forecast to keep rising for the foreseeable future and the stock now trades on a 6.7% prospective yield.

Over-50s financial services and travel specialist Saga (SAGA) trades on a 7.1% yield. Historically it has been a 4.5%-5% yield stock; the yield has recently shot up as a result of the share price falling on a profit warning.

Analyst forecasts still imply progressive dividend growth for the company, yet investors may wish to tread carefully until more information is released from Saga as to why its broking business has recently disappointed.

Pub companies Marston’s (MARS) and Greene King (GNK) offer 6.8% and 5.9% prospective dividends respectively. Our preference as an investment is Marston’s. It has been selling
bad pubs and building good ones. It refuses to discount food and drink which is helping to protect profit margins – the opposite of many other companies in the leisure sector.

The business’s property estate is 94% freehold and it has a net asset value of 147p per share – versus a 114.8p current trading price.

Construction business Galliford Try (GFRD) trades on a heavily discounted valuation thanks to problems on legacy construction contracts. However, underpinned by its housebuilding
and regeneration arms, it has a credible-looking plan to boost profit more than 60% out to 2021. This should support the dividend which has a 7.5% prospective yield.

WARNING SIGNS

High dividend yields can often be a warning sign that the market lacks faith in earnings forecasts – so don’t rush to buy any company off our list of 5%+ yielders without proper research.

‘Over the last 18-24 months, there has definitely been a theme of dividend cuts from some very high-profile companies,’ says David Goldman, co-manager of BlackRock Income and Growth Investment Trust (BRIG).

‘When you look at the FTSE 350 by number, the vast majority are still growing their dividends. You’ve still got 75-80% of FTSE 350 companies growing their dividends with the balance being split between those that are keeping the dividend flat and the odd cut.’

So which companies look vulnerable to a cut? A profit warning from Centrica (CNA) in November 2017, which saw 2017 earnings per share guidance cut to 12.5p (from consensus of 15p), makes us far less confident that its dividend will be maintained.

The business is being hit by competition alongside the threat of price caps and increased regulation. Analysts are already pencilling in lower dividends, so don’t go chasing this stock expecting to make 8%+ yields a year.

Other stocks potentially in line for a dividend cut include satellites network operator Inmarsat (ISAT) and telecoms business TalkTalk (TALK).

The former has a stretched balance sheet after spending heavily on infrastructure with net debt upwards of $2bn.

TalkTalk faces a highly competitive environment and suffered significant brand damage after a cyber-attack in October 2015. Despite already cutting the dividend by 50% in May 2017, some analysts think further cuts are necessary.

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HOW TO PROTECT YOUR INCOME

Dividends are never guaranteed to be paid. If a company endures poor performance, a big financial shock or spends all its cash on a big acquisition the dividend could be trimmed, suspended or even cancelled outright. In these circumstances investors can face a double whammy as they lose the income and suffer a
fall in the value of their investment as negative news on the dividend affects the share price.

Anyone owning a fund should benefit from diversification in this situation. A setback with one portfolio holding in a fund wouldn’t have as much of an impact as compared to an individual stock. We’ll talk about income funds later in this article.

SAFETY CHECKS

For investors owning individual stocks, it is fairly easy to carry out safety checks on a dividend. The most straightforward is to see how many times it is covered by earnings. This is known as dividend cover.

Dividend cover of less than one suggests the dividend is being paid out of debt or cash savings which is unsustainable in the long-term or perhaps through shares in the form of a scrip dividend which can dilute existing shareholders over time.

As a rule of thumb, dividend cover of two times or more is generally seen as safe. However, it is important to stress that dividends are paid out of cash rather than earnings which can be massaged by clever accounting.

Free cash flow can be a better way to test a company’s ability to pay dividends than earning per share. Free cash flow is the amount of cash generated from operations minus capital expenditure. It is excess cash used to expand production, develop new products, make acquisitions, reduce debt and pay dividends.

‘When we think about dividend cover, we feel it is very important to differentiate between companies with a high payout ratio because they are capital light and can afford to have a high payout ratio, and those with high payout ratios which operate in very capital-intensive industries (mining, oil and gas), and those make us more nervous,’ says Goldman at BlackRock Income and Growth Investment Trust.

In the next table we highlight companies whose generous dividends are comfortably covered by free cash flow. All the names included in our table have yields above 5% and forecast dividends covered at least 1.75 times by cash flow.

Among the names on the list, Redde (REDD:AIM) with a 6.7% prospective yield provides a range of accident management and legal services to motorists and insurers. It is well known for having a generous dividend policy.

‘Redde’s model releases significant operational and financial resource for insurer partners and allows them to focus on optimising underwriting returns whilst maximising the propensity for policyholders to renew through an efficient and simple service offering delivered well,’ said stockbroker N+1 Singer in September 2017.

‘New contracts with new insurer partners have been secured and existing partners are working more closely with Redde. Key competitors have fallen away or are seeking other strategic goals.

‘We feel that it is fair to assume that there are clear opportunities for Redde to outperform our forecasts, even if new opportunities do not reach the same scale as existing relationships.’

Elsewhere, Phoenix (PHNX) has a prospective yield of 6.5%. This highly cash-generative company is Britain’s largest owner of life assurance funds closed to new customers.

Phoenix says this business model enables it to focus all of its energy and expertise on improving the performance of funds without being distracted by the need to win new customers.

THE BENEFITS OF INCOME DIVERSIFICATION

Because it is impossible to eliminate the risk of a dividend cut entirely it is better to run a diversified portfolio of dividend-paying stocks (or invest in a fund).

This way if one company cuts its dividend your overall income is not too heavily impacted. Given the cost and practicalities involved in running a large portfolio yourself it can make sense to use income funds to achieve this diversification.

If you want genuine diversification, make sure you check the holdings of a UK-focused equity income fund to ensure the product isn’t overly reliant on a handful of sectors to generate that income.

Financial stocks and oil and gas companies account for 43% of the total forecast cash dividend payments from the FTSE 100 in 2018 according to AJ Bell.

And just two companies account for a quarter of all FTSE 100 cash dividend payments in the year, being Royal Dutch Shell (14%) and HSBC (HSBA) at 9%.

AJ Bell’s data shows the average forecast dividend cover for the FTSE 100 in 2018 is 1.63 which is lower than at the height of the financial crisis 10 years ago.

The highest yielding stocks in the FTSE 100 have even lower dividend cover at just 1.37 times on average.

The 10 companies with the lowest dividend cover in the blue chip index include three of the highest dividend yields: Centrica, Direct Line (DLG) and BP (BP.).

All but two of them – Hargreaves Lansdown (HL.) and St James’s Place (STJ) – are forecast to yield significantly more than the FTSE 100 as a whole.

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HIGH YIELDING FUNDS

Global equity income funds are likely to fall short of the 5%+ yield target we’ve set in this article. For example, most investment trusts in this category have a 3% to 4% yield.

One exception is Liontrust Global Income (GB00B56S8Y21), a unit trust which yields 5.4%. It only invests in high-yielding stocks with ‘unusually’ strong cash flows where investors have low profit expectations.

It says: ‘Strong company cash flows (after investment spending) are a good indicator of strong growth in future reported profits.’ Some of its holdings include Russian steel group Severstal and South African mobile communications group Vodacom.

In general, you may have to look at more specialist funds such as one investing in infrastructure assets or emerging markets, or one with ‘enhanced’ income, in order to hit the 5%+ yield goal.

For example, Threadneedle Emerging Market Local (GB00B88S8291) yields 7.5%. It invests in emerging market government debt and companies which are based in, or have significant operations in, an emerging market.

Fidelity Enhanced Income (GB00B87HPZ94) has a 7.1% yield and is not your typical equity income fund. It invests in a range of higher yielding UK shares to form a portfolio similar to a traditional equity income fund and it also uses derivatives. That latter involves selling some of the potential future capital gains in exchange for a higher income today.

L&G Dynamic Bond Trust (GB00B1TWMY10) yields 6.6%. This strategic bond can invest in a wide range of fixed income assets, from government bonds to high yield, and make use of derivatives to enhance returns.

Among investment trusts, there are numerous funds invested in debt which offer yields typically in the range of 9% to 14%. For example Carador Income Fund (CIFU) yields 13% and invests in secured loan portfolio through CLO (collateralised loan obligation) transactions.

INVESTMENT TRUSTS AND ETFS FOR HIGH INCOME

Lower down the yield spectrum, there are some property-related investment trusts with yields in excess of 5% such as Impact Healthcare REIT (IHR). It yields 5.9% and invests in properties linked to the UK care home market. Additional value is expected to be generated through refurbishments and extensions.

Exchange-traded funds can also be used as investments to obtain income, although you must consider that products tracking the highest yields may be higher risk than you think.

They may provide exposure to companies whose yields are high as a result of their share price being low – which, as we discussed earlier in this article, can be a warning sign which may lead to a dividend cut.

iShares UK Dividend ETF (IUKD) is a relevant example and has a 5.19% yield. ‘We do not believe that this fund has the potential to outperform its category peers over the long term,’ says Hortense Bioy, an analyst at Morningstar.

‘The iShares UK Dividend ETF is part of a shrinking cohort of passive offerings that focus on the highest-yielding stocks with no dividend sustainability screens. The ETF offers exposure to 50 UK stocks with the highest one-year forecast dividend yield.

‘This strategy may suit investors seeking high and regular income, but it may come at the expense of long-term capital appreciation as companies that pay large dividends may do so at the expense of their growth or overall financial health.

‘Also, simply selecting the highest-yielding stocks can be risky as some high-yielding stocks may be companies with poor fundamentals whose stocks are trading at low prices, reflecting the fact that the company may be in trouble,’ adds Bioy.

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HOW TO GROW YOUR INCOME

Consistent dividend growth is typically a hallmark of a high-quality company with the ability to generate plenty of cash flow. This may well be rewarded by a higher share price as investors rush to gain access to this cash flow.

You can review historical dividend growth by looking at dividend payments over previous years on financial data websites like SharePad and Stockopedia, as well as on Shares’ website. Some larger companies may even publish this information on their own websites, as is the case for HSBC among others.

And if you are in a position to reinvest the income from your holdings in dividend growth stocks, rather than taking the cash straight away, you can in theory benefit by steadily increasing your exposure to an income stream which itself is already growing.

AJ Bell’s Dividend Dashboard report shows the positive impact dividend growth can have on the total return from a stock. Of the 26 current members of the FTSE 100 which have grown their dividend every year for the last decade, only utility firm SSE (SSE) has not comfortably outperformed the index on a total return basis.

INVESTMENT TRUSTS WITH A HISTORY OF DIVIDEND GROWTH

The Association of Investment Companies (AIC)publishes a list on its website of ‘dividend hero’ investment trusts which have increased their dividends each year for 20 years or more.

Most of these trusts yield less than 5%, although you’ll find plenty of good examples of funds that deliver returns in excess of 5% when also factoring in capital growth.

Just look at Bankers Investment Trust (BNKR): it yields 2.1% and has managed to give investors more dividends every year for the past 50 years. Over the past 12 months it has delivered 30%
total return.

Simply looking for the highest yield isn’t always the best route to finding a good investment, as we’ve explained earlier in this article.

For example, investment trust British & American (BAF) yields 13.5% and has increased its dividend every year for the past 21 years, thus it is classified by the AIC as a dividend hero. It invests mainly in investment trusts and UK quoted companies. While its yield sounds appealing, this trust provides a good lesson in also checking the share price performance and being comfortable with the underlying assets.

British & American’s shares have been fairly weak since summer 2017. Its net asset value has fallen by a third over the past year, according to Morningstar. Add back the dividend income and you’re still nursing a loss for the 12 month period. On a share price total return basis, you would have lost 15.8%. (TS/DC/JC)

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