Income is looking exceedingly good
IN AN otherwise gloomy week for economic news – firstly Europe is in crisis, next the US and China are having trouble sustaining their growth rates – a ray of sunshine has emerged for equity investors. Dividends are set to be big for the next 12 months, even without BP, which has been forced to suspend its dividend after the Gulf of Mexico oil spill.
According to Evolution Securities, dividend yields will be 3.79 per cent in the UK in the next 12 months and 4.04 per cent in Europe, excluding the UK. But it is dividend growth rates that are particularly impressive. Analysts at Evolution forecast growth of 9.42 per cent in the UK and 10.94 in Europe ex-UK.
So what is driving this dividend give-away? As analysts at UBS succinctly put it, we are living in a period of “equity surpluses in a world of deficits”. Even though the economy may have lost its way in recent months, companies are in good shape. They have been growing profits and amassing cash flow surpluses. But because of the uncertain macro outlook, firms are less inclined to spend this excess cash on growing their businesses, instead choosing to distribute it to shareholders.
The investment case for income investing is compelling. As UBS points out, equity yields look extremely attractive compared to other asset classes. It is the only class to offer a yield above its 10-year average. Also equity yields are above bond yields, which has happened only three times in the last 31 years.
But dividend futures on the Eurostoxx 50 currently show that dividends will be lower over the next three years then they were in 2008-2009, the peak of the financial crisis.
But futures are too pessimistic, says UBS, and they don’t seem to be taking into account the strong financial position of companies. As the chart shows, cash held by companies’ – as a percentage of assets – is at its highest level since 2003, the start of the last business cycle, and debt levels are falling. Dividend distributions are dependent on a company’s earnings, so strong balance sheets are vital for income investors.
But what is the best way to get exposure? Simply purchasing a stock that pays a dividend is a good start, but if you want more exposure then check out dividend yield exchange-traded funds (ETF). These ETFs screen stocks based on their dividend potential. For example, the iShares FTSE UK Dividend Plus Index only includes stocks that are the highest dividend payers. Rima Haddad, ETFX product specialist at ETF Securities, notes that some ETFs will distribute dividends as income to investors, while others will reinvest it, which will boost the total return.
Companies can sometimes cut their dividend, as proven by BP, so investing in an ETF gives you more diversified exposure, adds Haddad. If you are only investing in one physical stock then you have considerable risk that the company may not pay out, whereas if you invest in an ETF the risk is diluted since it will include multiple companies.
It can also be worth investing in specific sectors since some are bigger dividend payers than others. According to data from Lipper, the fund research firm, the pharmaceuticals sector has the highest dividend yield in the FTSE 350. Combined with oil and gas, mobile telecoms, multi-utilities and general financials, these sectors pay 45 per cent of all income on the FTSE 350.
So if you want something to perk you up during what is set to be a gloomy few months
for asset markets, income could be the perfect tonic.