Why high yield stocks are the best bet right now
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Associate Editor
David Stevenson Aug 27, 2010
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Share price falls aren't bad news for everyone. If you're trying to get a decent income from your investments, these days the stock market is one of the better places to look for it.
Savings rates on bank deposits are mainly rubbish. While ten-year gilts are only paying you a measly 3%. But, following its latest fall to a near seven-week low, the FTSE 100 index is now offering an average dividend yield of 3.6%.
What's more, plenty of high-quality UK stocks yield quite a bit more than this. And that's just in the short run. Looking longer term, there's another plus point with high yielders. If you want to make the most of your money in the market, dividends are by far the number-one key factor.
So here we look at how you can boost your dividend income – and your overall investment return as well.
The case for buying unpopular stocks
Buying high yielding stocks is all about fashion. Or rather, it's about the exact opposite.
We've written about this before, so here's just a quick re-cap. A high yield is saying that a stock has fallen right out of favour with investors.
In other words, they're not happy to buy it unless they can extract a much higher-than-average dividend payout from it. Chances are, the stock has become pretty cheap in price to earnings (p/e) terms, too.
This can happen for one or more reasons. Sometimes high-yielders are in sectors the market just doesn't like. Maybe there was a question mark over whether the dividend would be paid in full. Or perhaps there's always been a stigma about the company concerned.
But here's where a great opportunity can arise for investors who are prepared to take a contrarian view.
By buying when a share is unloved and cheap, you can lock in a tasty yield straightaway. Then at some stage in the future, you may find you've made a chunky profit too. That's as and when the market becomes keen on the stock once again.
Of course, most of the time, the payout is the only tangible thing you get from holding a share. Yet many people have no idea how much dividends add to the overall amount of money they can make.
Dividends are crucial for long-term returns
Author and GMO investment manager James Montier sums this up in his latest newsletter. "To those who charge around trying to guess the next quarter's make believe earnings number, the concept of dividends seems wholly irrelevant", he says. "But dividends are a vital element of return."
"Looking at the US market since 1871, on average over the very long-term, dividends have accounted for some 90% of the total return", he says. It's a similar story on this side of the Atlantic. "In Europe, 80% to 100% of the total returns achieved since 1970 have come from dividends (combining yield and real dividend growth)".
Although that 'up to 100%' bit is rather a stunner. It means that, in some European markets, almost all the long-term money that's been made has been down to dividend payments.
For me, that makes dividends a no brainer. High yield stocks that are steadily upping their payouts are a 'must have' part of any long-term portfolio.
Even better, when markets fall, high yield stocks tend to do better than the rest. That's because a decent payout level can help to protect a share price when times get tougher. As the chart below indicates.
The FTSE high yield index currently pays out just over 5%. The blue line shows the relative performance of this index compared with the FTSE 100 (in red). For much of the last three years, this relative has been almost a mirror image of the main UK blue chip barometer.
In other words, while the FTSE 100 has recently dropped back, high yielders have started outperforming again.
Source: Bloomberg
Yet, as Montier says – without pulling any punches – the market is still completely missing the point on the dividend front. As he puts it, "dividends have fallen out of favour with CEO as well as 'investors' – although it pains me to use that term for the seeming ADHD-afflicted speculators who dominate the investment scene today".
So the current 'churn and burn' attitude is providing a contrarian buying opportunity. At some point many of today's high yielders will return to favour. When that happens, investors who are prepared to snap them up at today's depressed prices will be quids in.
What to buy
What are the best big-dividend paying stocks to buy right now? If you're a regular Money Morning reader you'll know that over the last year we've come up with a steady stream of high yield tips.
For today, I'll mention just one, with a way of finding more. Morgan Stanley's European team have put together a list of stocks with "high and secure dividend yields". Among the biggest UK blue chips, just about top of the bill comes British American Tobacco (LN: BATS).
Sure, it makes cigarettes, and that's not to everyone's taste. But from an investment viewpoint, BAT looks a good bet. Despite churning out ever-growing amounts of cash, the stock is standing on a current year p/e of just 12.7 and a prospective yield of 5.1%. Further, Morgan Stanley is forecasting almost 9% dividend growth in 2011.
As for more ideas, my colleague Stephen Bland has developed a long-term investment strategy called the 'High Yield Portfolio' (HYP). The aim of the HYP strategy is to build a portoflio of UK shares that will pay out large dividends forever – no matter what happens to the markets.
If you'd like more information on starting a subscription to Stephen's The Dividend Letter newsletter, please call our customer service Team on 020 7633 3609.
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