Join our community of smart investors
OPINION

Jam today, please

Jam today, please
April 25, 2014
Jam today, please

Just how much you need to prefer the lower yielding one will obviously depend on some crucial factors:

■ the growth rate of the income that the two throw off;

■ how much variability there is between the two growth rates;

■ how the capital values of the two holdings are likely to change (particularly important, but hugely influenced by the long-term income production of the two).

Yet the difficulty is that these factors have to be estimated, and forecasts - especially when they go into details - too often bear little relation to what transpires.

This does not mean you sigh, shrug your shoulders and slap into an income fund, say, the 10 highest-yielding securities that you can find and have done with it. But it does present a dilemma selecting between candidates that are similar; and, in this context, 'similar' might mean any securities in the FTSE 100 index that come with a dividend yield that's half a point or so above the average.

To get down to specifics, let's start with Standard Chartered (STAN), whose shares look a decent candidate for the Bearbull Income Portfolio - they bring a 4.1 per cent yield on 2014's forecast pay-out and offer part ownership in a bank that may be as good a way as any into both Asia's developing economies and Africa's higher-risk frontier economies. But should I prefer Standard's shares to those of HSBC (HSBA), that, from its historic base in Hong Kong, has grown to be the world's second biggest bank and whose shares yield 5.2 per cent on the likely 2014 dividend?

True, HSBC has less focus on Asia and Africa than Standard and slightly more on Europe and North America. That could mean HSBC brings more exposure to the rickety banking systems of those continents, or is it better diversified than Standard? Obviously, there is no argument that HSBC is a much bigger operation - it gears up on equity of £110bn compared with £28bn at Standard - so it actually has a greater presence in developing economies than Standard. Does that put it in pole position, or is Standard's sharper focus on those economies more important?

Yet in asking these - and similar - questions, investors are really asking a deeper one: can one company grow its profits - and therefore its dividends - faster and more reliably? Whatever the City's banking analysts may protest, no amount of extra research is likely to bring a better answer to that crucial question. Nor will extrapolation from past dividend growth be of much help. Taking a cue from my efforts to find the London stock market's most reliable dividend-payers (Bearbull, 4 April 2014), I can compare the growth rate of the two companies' dividends since 1995 and the variability of the pay-outs.

On that basis, Standard is the clear winner, with an average increase in dividends of 10 per cent a year compared with HSBC's 8.1 per cent and with less variability - 12.3 per cent compared with 19 per cent for HSBC, whose pay-outs were badly hit in 2008 and 2009 by the global financial crisis; indeed, 2013's $0.49 dividend was barely more than half HSBC's $0.90 dividend in 2007, the year before the crisis. Still, HSBC's pay-out has recovered at a faster pace than its share price since 2009, which is why the yield gap between Standard's and its own shares is well above its 10-year average.

And that's the deal breaker. It is hard to imagine that the two banks will maintain their dividend growth rates into the coming decades. But let's assume that the gap in the growth rate - two percentage points - persists and that the long-term growth rates fall to 6 per cent for Standard and 4 per cent for HSBC. Yet even with that gap - with Standard's dividend growing 50 per cent faster than HSBC's - it would be 13 years before an investor buying now got more income from Standard's shares than from HSBC's. Not just that, it would be 21 years before the cumulative income from holding Standard shares exceeded the income from HSBC.

These time frames are simply too long to favour shares in Standard. Sometimes immediate income is preferable to more income in the future. Sure, finance theory tell us that the faster pace of Standard's dividend growth rate will make its shares more valuable than HSBC's and this will compensate for the absence of income. In other words, capital gains will make good the lost income, so - if need be - income can be created by peeling off a few Standard shares and turning them into cash.

The theory is fine, but it's a dangerous game. Shares once sold can't be sold for income again, nor will they generate dividends for the portfolio in the future. So, if the fund's focus is on income and the choice is between mature companies whose pay-outs are about as reliable as these things get, extra yield is likely to be the clinching factor. Much as Alice objected to the White Queen: "Sometimes it must come to jam today."