Until the middle of last year, most investors looking for an income stock would not have strayed outside the utility sector, where a mundane but dependable revenue stream, products that are unlikely to go out of fashion and a higher-than-average yield made water and electricity companies an ideal place to park funds away from the higher risks associated with so-called growth stocks. But things have changed. High-yielding shares can now be found in many other sectors, but the big question is which ones are likely to offer longer-term value and a steady income stream?
As the mechanics of the market dictate, for a share that offers an unusually attractive yield, returning to nearer the historical average means either an increase in the share price or a reduction in the dividend payout. The tricky bit is to identify the companies that are undervalued as opposed to those that are likely to cut the dividend.
Since the start of the credit crisis last summer, income investing has all changed. Companies not renowned for their defensive qualities have been delivering yields far in excess of those available from a straight cash deposit. Equity values have fallen, but as yet there has been no widescale reduction in dividend payouts. In fact, some sectors, like the housebuilders, where share prices have fallen as much as 70 per cent in the past nine months, have been steadily increasing their dividends. In this case, this is as much a sign of confidence as a continued reward for its shareholders who have seen their investments sharply reduced in value.
Check the cover
But it is important to ensure that the cost of the dividend is adequately covered by post-tax profits. Most investors like to see a dividend covered around twice by post-tax profits, so housebuilder Persimmon's dividend covered 2.7 times looks to be safe enough. But the yield is a mouth-watering 7.4 per cent, so is this a good investment? Most analysts tend to favour the housebuilders as a good long-term investment, given the need for more housing. So if investors want to invest now for the yield and are prepared to wait a year or two for the capital appreciation that will come when mortgages are more readily available and cheaper, then it looks as though Persimmon is a good investment.
There are no hard and fast rules, though. Lloyds TSB was the best yielding of the UK high-street banks before the credit crunch last August, but its thin dividend cover of just 1.3 times meant that most people were looking for the dividend payout to be cut. This did not turn out to be the case. And now Lloyds, with its traditional trading mix, looks to be one of the more dependable clearing banks. Others, such as Royal Bank of Scotland - long regarded as a model of corporate efficiency - yields 10.2 per cent, as do Alliance & Leicester and HBOS. So it will take less than 10 years to earn in dividends what it cost to buy the shares. Meanwhile, the rate of return is far in excess of what the banks are offering on their deposit accounts. So, assuming that the bank does not go bust or cut its dividend payout, any of these look to be a good investment. But such assumptions can be rash, as Northern Rock has shown. In fact, yields are an indicator only, and ultimately investors have to make a decision on how they view companies' strengths and weaknesses.
But most of the current high-yielding stocks will not go bust, and the ability to offer an attractive yield will depend as much as anything else on the basic ingredients that differentiate a quality company from a struggling one or a company geared to spending on expansion against one simply handing back excess cash. Many of the current high-yielding shares, most notably in the financial sector, are attractive as a result of a general markdown in share prices as investors become much more risk-averse. But what happens when the current bear trend in equity values starts to turn?
Weeding out the underperforming sectors
Before identifying some sectors that might offer a decent yield as well as the prospect of capital growth, it is probably worth ruling out those sectors that will struggle to perform in the short to medium term. Travel and leisure stocks are relatively poor yielders even after the steady decline in share prices. What's more, a squeeze on consumers' disposable income is likely to make it tough to generate much capital growth. Much the same can be said for retailers, although there are some high-yielding shares such as Debenhams and JJB Sports (although in the case of JJB, the dividend payout is under pressure and is not even covered by post-tax profits).
Ultimately, yield growth is only sustainable when accompanied by earnings growth. So an immediate indicator for indentifying a company that will offer solid dividend growth is the price-earnings (PE) ratio. A high PE ratio suggests that either future earnings growth is already in the price of the shares or that the shares are overvalued, which means that the share price is likely to fall. Once again, housebuilders provide an interesting exception to the extent that some offer a yield that is higher than the PE ratio. But, in this case, it is more likely that share prices will recover rather than earnings decline significantly.
What's more, it is vital to look just beyond the yield currently available because recent market volatility and shifts in investor trends serve to cloud the picture. As investors shift away from what are regarded as high-risk sectors, the yield on out-of-favour stocks increases and the yield on traditional high-yielders falls. Scottish & Southern Energy provides an ideal example of the latter. The energy provider recently overtook E.ON to become the second largest supplier of electricity and gas in the UK, and is also the biggest operator of wind farms. Customer numbers have increased by 650,000 in the nine months to 31 December 2007, to 8.5m, benefiting from a commitment not to follow rivals and increase prices before the end of March this year. Cash-generation remains strong, and the company maintains that it is on course to deliver at least 4 per cent growth in dividend payouts for each of the next three years, ahead of the sector average of 3.5 per cent. The shares trade at 1,430p and Credit Suisse reckons that fair value is 1,775p. But the yield is a relatively unexciting four per cent. The company is a classic yield play for income growth, but the smart investors moved in long before the share price started to accelerate rapidly.
There is also a growing cloud of uncertainty surrounding some utilities because of claims of market abuse. Scottish & Southern has been , while Severn Trent has already been .
At some point, when risk aversion subsides and investors take their money and put it into growth stocks, the share price for Scottish & Southern will fall and the yield will become more attractive. But it would be wrong to suggest that income shares over the longer term will revert to the norm, ie boring safe companies that provide basic essentials. The current economic climate provides opportunities for investors to invest in today's high yielders, which will turn into tomorrow's growth stocks. After all, a steady yield is attractive in that it provides a relatively predictable revenue stream, but no-one with an income-slanted portfolio is going to object to some capital growth as well.
Downside risk
In an ideal world, the shares in the company that you have just bought go up in value and the dividend is maintained or increased. But given the current climate investors would be better served by trying to decide the balance between yield attraction on the one hand and potential price depreciation on the other. If the dividend is higher than any fall in the share price, you'll still have captured a positive return. So assessing the health of a company remains all important. It is also useful to try to gauge exactly how much further downside risk there is. This matters because in the case of banks and other financial institutions, news that another bank is in big trouble could see prices slide even further. But a for a house builder with relatively light gearing, a strong land bank and low reliance on any one part of the housing market, it gets to the stage where the share price falls below the company's break up value. At this point, there should be a greater possibility that the share price has reached the bottom. Either way, buying shares in a healthy company valued below net assets and offering a chunky yield has to have its attractions.
