A rewarding strategy

Wednesday, 31st August 2016 10:45 - by Eric Chalker

This is an article about dividends.  The generation of profit is fundamental to equity investment, even though share prices are often driven by other factors.  Companies can generate profits without distributing them, but for some investors the distribution is what matters.

It is a sad fact that too few savers with money to invest and desiring an income from it understand what can be achieved with a little study of company shares.  Prompted by a friend’s recent enquiry, I was able to find as many as 24 stocks in 17 sectors with an historic dividend yield either exceeding or close to 4.0 per cent.  This was using the Financial Times listing, published each day, which shows (as do a few other newspapers) the basic statistics of interest to investors.  The list is limited to those companies which judge it to be in their interests to pay for publication and it is unfortunately the case that the dividend yields shown are not always accurate, but it is a quick and easy way for income seekers to compile a list for further study.

Except for one, all of the 24 mentioned are main-listed and even at this level the list was not exhaustive, but I did consciously exclude some which could not justifiably be included.  The mean average yield of my list a week ago, as reported by the FT, was 5.5 per cent, which given the diversity is frankly astonishing.  One factor, naturally, is market doubts that the dividends are sustainable, but in most cases a look at the fundamentals goes a long way to dispelling such doubts – for me, anyway. 

Some of the dividends have been flat for some time with nothing to suggest they will rise soon, with the yield elevated by a falling share price, but others are being paid on rising earnings with balance sheets that, on the face of it, look sound.  For a few in my list it has been publicly suggested that the recent dividend is not sustainable, but, on the other hand, if one were to be less choosy more could be added.

A case in point

 Over the years, I have found on more than one occasion that a good dividend paying portfolio can be constructed that will, with a small amount of attention, provide an income increasing annually well above the rate of inflation.  I put together one such portfolio 4½ years ago, comprising ten stocks of equal value spread across ten sectors.  They are reviewed quarterly and changes are made when these seem justified to increase the dividend yield.  One holding was split and one transferred in, so there are now twelve holdings, some up, some down, but there has been no new money and no reinvestment of dividends.  From the original cost base, the overall capital appreciation is 45.6% (nearly 8% pa).

The dividends have grown commensurately.  First year dividend yield was 4.9 per cent.  By the fourth year the income taken from the portfolio had risen to 6.7 per cent of the original investment and in money terms was 23.6 per cent above the first year’s income, way above inflation.  Changes made shortly before writing this article should mean that the current (fifth) year’s income will be more than 15 per cent above last year’s.  In an ISA, or with a total no more than £5,000, dividends are all tax free. 

If capital appreciation is maintained, the total return over the five years (ie including dividends) seems likely to be in excess of 75 per cent.  If dividends had been reinvested, the outcome would have been greater, but the objective was income.

Managing a dividend portfolio

When managing a portfolio solely for income, it is my practice to sell a stock when the share price has risen much faster than the dividend, so causing the prospective dividend yield to fall below what is acceptable.  The full sale proceeds are then reinvested in another stock which, perhaps because it has fallen out of favour, is showing a better dividend yield than the one which has been sold.  This is not done blindly, of course, but only after reading what has been published about the company and its performance.  Sometimes a stock will be sold for a different reason, but this has happened only rarely.

In the course of managing this portfolio, there have been 13 sales, with an average gain of 39.3 per cent and no losses.  All but a tiny amount has been reinvested and in the last 12 months the portfolio has still achieved a dividend yield of 4.9 per cent on the total sum invested.  Only two of the original holdings remain, Sainsbury’s and Shell, both down a fifth in value but still paying dividends of 4.0 and 5.6 per cent respectively on the sums invested.  Furthermore, despite what in numerical terms amounts to a complete turnover of the portfolio, it is still well diversified.

The conclusion has to be that one of the best ways of securing both income and capital growth is to invest in good dividend paying companies.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

www.uksa.org.uk

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.