Dividends may be 'dull' – but they pay

By Deputy Editor Tim Bennett Nov 27, 2009

Tim Bennett

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Who needs dividends? The biggest gainers in this year's 'dash for trash' rally have been the stocks of companies that can't afford to pay any – such as banks and house-builders. Investors have ignored big blue-chips – still paying reliable, dependable dividends – as being too dull.

But that's a mistake. Dividends are critical to making decent money from shares in the long run. For example, based on capital gains only, £1 put in UK shares in 1900 would have grown to £161 by the end of 2006 ignoring inflation, according to ABN Amro. If you'd reinvested rather than spent your dividends, you'd have £21,174. This vast gap is all down to the wonders of compounding. In the 50 years to 2008, equities returned around 7% a year in real (inflation-adjusted terms). At that rate, every pound in dividend payments you reinvest would roughly double its buying power after ten years.

Dividend payers are better in the long run

Dividend payers tend to be good for long-term capital growth, too, because they are usually well run. Managers must focus on generating the necessary cash flow to meet payouts as well as covering operating costs and interest charges, which is good discipline. Future share-price growth – which is what you're betting on if a stock pays no income – is no more than a promise. But a dividend is hard cash in your hand.

Of course, there's no point in a firm enticing you with a decent one-off dividend if it can't be maintained. Giant insurer AIG last year proved that a decent yield doesn't guarantee sound management (in September 2008, just before it was bailed out by the American government, it offered a creditable 4%). The following are key stress tests.

Watch out for very high yields

Equity income is measured using the dividend yield (the share price divided by the annual dividend). So if the share price is £1.20, the interim dividend was 2p a share, and the final dividend 5p a share, the yield is 5.8% (2+5/120 x 100%). The higher the better, but with one big caveat.

FTSE 100 shares pay an average yield of around 3.5%, so unusually high yields may simply be the equivalent of a bribe to tempt you into a duff stock. Take the Dogs of the Dow FTSE investment strategy, which involves buying the top-yielding stocks in the market. Since April 2007, it's been a bit of disaster. For example, the Daily Mail's Midas FTSE Dogs portfolio would have reduced a £10,000 investment to £5,039 (as at 21 November), against £8,075 for the equivalent FTSE 100 investment.

So, what makes for a robust dividend?

The most important test is dividend cover. This measures the number of times the firm could have paid (or "covered") its annual dividend. One option is to divide profit before dividends, by the total paid out in dividends. So if profits are £100m, and the annual dividend £50m, the latest dividend is covered twice. The higher, the better. Cover tends to drop in a recession with profits under pressure. Twice or more is ideal, but can be hard to find – anything below once is a red flag. A once-profitable firm having a bad year can pay its latest dividend out of past profits (known as "retained earnings"), but it can't keep repeating that trick.

It's useful to do the cover calculation on a cash-flow basis too – profits are often based on some subjective accounting decisions, whereas cash flow is much harder to manipulate. Take annual free cash flow (operating cash flow after interest and tax have been paid and the firm has covered essential spending). Then divide it by the cash dividend in the cash-flow statement. Low cash cover suggests the directors may be over-optimistic about the company's ability to raise or maintain future payouts.

And consider cash flow itself. A reliable dividend-payer should be generating steady operating cash flows (near the top of the cash-flow statement) every year. Some sectors – utilities for example – are much better at this than others. A sudden dip is a warning that dividends may be under threat, as chopping the dividend can be a quicker way to save cash than cutting operations.

What to buy

Even the manager of the biggest bond fund in the world, Pimco's Bill Gross, reckons blue-chip equities look a good bet just now. He favours utilities in particular, as he expects the future to be one of low economic growth. In theUK market, Scottish and Southern (LSE: SSN), yielding 6% or National Grid (LSE: NG), yielding 5.5%, are good bets. Consumer goods firm Unilever (LSE: ULVR) is a decent play on non-cyclical spending and yields 4.3%. Meanwhile, drugs giant AstraZeneca (LSE: AZN) offers 4.6% and trades on a forecast p/e of just 7.3.

For more on dividend investing and high-yield stocks, take a look at Stephen Bland's newsletter, The Dividend Letter.

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Published in How to invest | More articles by Tim Bennett

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