Investing for income

As share prices have tumbled over the past few months, the resultant hike in dividend yield for many companies has given investors seeking income something to think about. Our expert commentators on equity and fund investments, Richard Hunter and Mark Dampier look at the market and give investors food for thought. Remember that investments can fall, as well as rise, in value.

by Richard Hunter, Head of UK Equities

As a general rule, investors will be looking to either income or capital growth when picking their portfolio, or even a mixture of both. Here we will examine the concepts behind investing for income.

The traditional wisdom is normally that in the early years an investor's portfolio will be geared to capital growth and then as retirement approaches or arrives, the requirement may well switch to income. There could be other reasons for an investor to want to skew the portfolio towards income, such as the ability to benefit from reinvesting dividends over the years - this form of compound interest is an extremely powerful tool. For example, according to the most recent Barclays Equity Gilt Study, £1,000 invested in 1945 in shares would now be worth £2,960, adjusted for inflation. If the investor had reinvested the dividends, this figure would rise to an astonishing £45,770. Of little surprise, then, that Albert Einstein described compound returns as the "eighth wonder of the world".

Given the current base rate of 5.25%, any return of around that level in terms of the dividend yield might look attractive. And although the average dividend yield for the FTSE 100 stands at 3.8%, there are currently 19 stocks with a yield of 5% or more. Yields are variable of course and are not guaranteed.

At this stage, it is worth remembering the share price relationship to the yield. The definition of the yield is the gross dividend per share divided by the current share price expressed as a percentage - for example, in the case of Yell Group, the most recent overall annual dividend (interims plus full year added together) comes to 17.1p, divided by the share price (199p) gives a yield of 8.6%. Two words of caution here - this figure is historic, and so the fact that a dividend was paid "last year" is not a guarantee that it will be paid this year (even though companies will resist any temptations to lower the dividend if at all possible, for the negative signals it sends out).

Secondly, the higher yield can sometimes be explained by the fact that the market has effectively suppressed the share price because it feels that prospects for the company generally are unclear, which in turn means of course that a constant dividend at a lower share price will automatically translate to a higher yield. It is worth noting that before its shares were suspended, and in the absence of any likelihood whatsoever of a future dividend being paid, Northern Rock was - in theory - yielding 30%. A very high yield can be a sign that the market regards the stock as a basket case. A scan across the highest yielding stocks in the FTSE100 confirms this fact, whilst also reading like a "Who's Who" of companies who have suffered in particular during the recent unfolding credit crisis. Of course, financial and property stocks are included, along with some retailers whose current prospects are under extreme scrutiny.

As can be seen from the "top ten" in the table below, the list is dominated by banks and property shares - seven of the top ten in fact. Only really Lloyds TSB and Kingfisher have been high-yielding stocks in more recent years.

Investors should also keep an eye on dividend cover, in other words, the ability of a company to pay such a dividend. This is expressed as the ratio between net profits (earnings per share) divided by the dividend per share. Thus, a company with eps of 10p paying a dividend per share of 2p will have a dividend cover of 5. As a general rule, anything over 2 is considered relatively safe in terms of the company's ability to pay a declared dividend. By the same token, anything under 1.5 could be a warning message, whereas anything less than 1 (see Rentokil below) actually means that the company is paying the dividend from the previous year's retained earnings - buyer beware.

One final point to bear in mind is that dividends are of course treated as income for tax purposes, and investors should also factor this into their calculations.

Top ten yielding FTSE100 stocks, dividend cover and market consensus:

* source - ShareScope, as at 06/03/08

by Mark Dampier, Head of Research

If you find the thought of choosing shares yourself rather daunting, then a professionally managed fund might be the answer. This gives you immediate access to a diversified portfolio of shares selected by an expert manager. Fortunately for investors seeking income, some of the country's top investment brains are to be found in the Equity Income sector.

In my opinion two of the best are Neil Woodford (Invesco Perpetual Income, Invesco Perpetual High Income) and Bill Mott (PSigma Income). They both have more than twenty years experience and over that time have earned a reputation for astute long term investing. They manage money with a similar philosophy, which involves analysing the UK and global economies and choosing stocks that they believe are likely to prosper in that environment.

These similar philosophies do not mean that they always come to the same conclusions, though. Fascinatingly, Neil Woodford's portfolio is currently skewed to shares that are not economically sensitive - in other words they should perform relatively well when times are tough. Bill Mott, by contrast, believes we have already seen the worst of the slowdown and that the market consensus is too negative. He has therefore been investing in companies such as banks that he believes could bounce back strongly from their recent troubles - Neil Woodford has no banks in his portfolio.

These funds therefore provide very different approaches to investing in the current climate. They also currently yield more than 3%, with forecasts that this could rise this year. Only time will tell which of them is right in the short term, but I would back both Mr Woodford and Mr Mott to deliver superb returns for their investors over the long term.