Dividend yields key in sideways market

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Shares with high dividend yields should be the investment of choice for long-term growth investors, as well as income seekers, while equity markets remain volatile, but stuck in a range, analysts now argue. But some warn that private investors must avoid overpaying for these stocks by focusing on companies’ valuations and the sustainability of their payouts.

In research published this week, Morgan Stanley’s Global Equity Strategy Team forecast that US and European stock markets would remain flat or decline – making dividends a more important component of returns in future. “In range-bound, or bear, markets, dividends are a critical driver of equity returns – and that’s our forecast for the developed markets,” the analysts concluded.

They studied periods before recent market booms, to quantify the contribution made by dividends over the long term. With the past 40 years, price growth has been the more important factor. “Since 1970, the compound annual growth rate (CAGR) of price returns in the MSCI World index has been 5.1 per cent versus 8.3 per cent on a total return basis – ie, capital gains have been the majority driver of shareholder returns,” the analysts admit. However, they point out that this period incorporates the 1980s and 1990s, which featured “outsized price returns” that are unlikely to be repeated.

Over the longer term – taking in extended periods of flat and falling prices – dividends contribute around half of total returns. Since 1901, for example, US equities’ total return CAGR, including dividends, has been 9.5 per cent, compared with 4.9 per cent for price returns only, according to the analysts. “The importance of dividends is accentuated in periods when equity markets are range-bound or falling ... dividends generate the majority of an investors’ total return,” they say.

Broker Killik & Co has already warned clients that “markets could remain range bound for some time” and agrees that higher yielding investments “should prove more resilient than non-income paying investments in volatile markets”.

It uses the example of the post-dotcom boom to show the power of dividend reinvestment over shorter time periods. At the end of last year, the FTSE 100 index was 20 per cent lower than its closing high on December 30 1999. But the FTSE 100 Total Return index, with dividends reinvested, was up by more than 21 per cent over the same 12 years.

In the UK, there have been periods when this dividend effect has been even more pronounced, says Simon James, founding partner of Gore Browne Investment Management. He cites data suggesting that “the combination of dividend yield and dividend growth has constituted the entire return from equities” for four decades. He adds that the valuations of dividend-paying stocks are at the lower end of the spectrum, even though many companies are generating some of their strongest earnings.

Morgan Stanley’s team says the appeal of high-yield stocks for income investors has become more obvious as bonds have been heavily bought, pushing their yields down. Across developed markets, the spread between equities’ dividend yields and bond yields is close to record highs: in Europe, dividend yields are now 50 per cent higher than some government bond yields, and above the yield on corporate bond indices.

But Katherine Garrett-Cox, chief executive of investment company Alliance Trust, suggests high-yield stocks can even be a stopgap holding for growth-oriented investors. “Dividend income pays shareholders to wait for capital growth to reassert itself,” she says.

Statistically, it is the highest yielders that deliver the highest total returns. When Morgan Stanley split stocks into quintiles based on dividend yield, it found the best European performers came from quintiles 1 and 2, and the best US performers from quintile 2.

PSigma Investment Management expects this trend to continue. “It is our strong view that dividend yields will continue to pay the larger part of equity returns in the years ahead,” says chief investment officer Tom Becket.

Investors still have to be highly selective, though, says James at Gore Browne. “It is important to focus upon strong business franchises, dominating their global sectors, with strong balance sheets and excess operating cash flows,” he advises. “There are many large and medium-sized companies in the UK which have such characteristics, and which have sales growth from the faster growing parts of the world. It is important to focus upon these, and to avoid banks and retailers, which will face significant headwinds for many years.”

To help identify them, Morgan Stanley’s analysts carried out two stock screens. First, they isolated companies with a dividend yield higher than their corporate bond yield. Then they searched for evidence of sustainable dividend payouts, using four criteria: a high and rising dividend yield; a payout ratio (of dividends to earnings) that is “not too onerous”; a strong balance sheet; and a free cash flow yield (free cash flow per share divided by the share price) greater than 5 per cent.

Companies meeting the criteria, and yielding more than 4 per cent, include: Pfizer and Philip Morris in the US; and BAE Systems, AstraZeneca, Wolters Kluwer, Total, Renault, Royal Dutch Shell, Philips, Siemens and BMW in Europe.

Nevertheless, Gemma Godfrey, head of investment strategy for advisers Brooks Macdonald, says investors need to do more digging of their own. “Balance sheet strength, purchasing power and valuation upside should also not be ignored, she says.

Dean Turner, investment strategist at HSBC Private Bank, gives similar advice. “Buying companies on the basis of their yield alone can prove costly if the dividend is cut, which is why it is crucial to identify companies with the ability to grow their distributions.”

Killik & Co recommends buying funds of high yielders, such as Schroder Income Maximiser, and Invesco Perpetual Income.