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How shares with low yields can pay the most income

 
David Brett
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Investors are often tempted to buy shares which promise bumper dividends today, largely because they need the income immediately, perhaps to support early retirement.

Those who can wait longer may want to consider an alternative – investing in companies that offer the potential of fast dividend growth.

Companies which can grow their dividends rapidly can deliver far better returns than today’s higher yielding stocks, but investors need patience as we explain below.

What is dividend yield?

Yield is the income an asset generates divided by the asset's capital value. If company A's shares are worth £10 each and it pays an annual dividend of £1 then its dividend yield is 10%.

What is dividend growth?

Dividend growth is the amount the dividend grows year-on-year. If company A pays £10 in year one then £11 in year two its dividend has grown 10% year-on-year.

Yield or growth: what’s more important?

In the example below, we make two hypothetical investments of £10,000 in company ‘A’ and ‘B’. We assume dividends are reinvested. We also make the bold assumption that the share price of each stock won’t move, to remove them from the equation. The reality, as we all know, is that share prices can be volatile and can rise and fall.

  • Company ‘A’ starts with a dividend yield of 3% and grows its dividend by 10% per year.
  • Company ‘B’ starts with a dividend yield of 7% and grows its dividend by 3% per year.

After 22 years, the investment in company ‘A’ starts to outperform. After 25 years, the investment in company ‘A’ is worth £153,000, compared with £113,000 for company ‘B’ – a 35% difference.

Chart illustrating Dividend growers can provide higher income over longer periods

Where can I find sustainable dividend growth?

Nick Kirrage, an equity value fund manager at Schroders, said: “It may come as a surprise that one of the best sources of dividend growth come from companies that have actually cut their dividends. Dividend cuts reflect both past difficulties and future potential.

“They are rarely welcomed by investors, so when companies do cut their dividends their share prices tend to fall significantly as a result.

“However, history shows that over time share prices recover and dividends grow much faster than the market expects.”

As an example, Legal & General was forced to cut its dividend during the recession. The business’s share price suffered badly, falling to 23p at its low in 2009.

However, as can often happen at times of panic, these fears were significantly overplayed and today the group’s share price is around £2.70 and it has raised its dividend by at least 15% in each of the last five years.

This situation also highlights that there are no guarantees when it comes to companies paying dividends. Investors might prefer to invest in bonds, which pay a more stable dividend.

Do I prioritise dividend growth potential over current high income?

Investors need to reach a balance. Kirrage said the ideal stock would meet three objectives – a high dividend yield but with the promise of capital growth and dividend growth. In reality, he says, few shares can match all three criteria.

“As an investor you want to find shares in a certain sweet spot,” he said. “You want a cheap share price, high income and high dividend growth. But every other investor also wants this. You normally have to sacrifice something.

"For us as value investors, we might buy a bank with no dividend yield. Banks are cheap and have the potential to rapidly grow dividends. Many have been reinstating payments after a period of no dividends.”

As well as banks, Kirrage also considers some miners and supermarkets, such as Tesco in the UK, to be candidates that are close to the sweet spot.

Chart illustraing the three aims of investing: capital growth, dividend growth and dividend yield

If I need high income today, can I trust the yields on offer?

Income investors should pay attention to “pay-out ratios”. These hint at whether a company, or sector, can afford to keep paying dividends at the same rate.

The pay-out ratio is the proportion of profits a company is using to pay dividends. The higher the pay-out ratio the more of its profits a company is using to pay the dividend. High pay-out ratios can put dividend growth at risk and even threaten the viability of future pay-outs.

A good fund manager will include this as part of their analysis when selecting stocks.

The chart below shows the range of pay-out ratios for different stock market sectors between 1987 and September 2016 with the orange line marking the average. The yellow dot shows the ratio at the end of that period. The data covers developed markets, excluding the US.

Consider the example of the financials sector, which is made up largely of banks. It had a relatively low pay-out ratio compared to other sectors and compared to its own typical range. Energy stocks, in contrast, had a very wide historic range and were at the very top end of it.

Chart illustrating which sectors are paying out high dividends compared with earnings

Important Information: The views and opinions contained herein are those of David Brett, Investment Writer, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

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