The world's best dividends

Any manager of a successful income fund will look for two things: quality and sustainability. Utilities, telecoms and large-cap pharmaceutical companies have traditionally been the beating heart of any income portfolio, but they're looking pricey, and there are question marks over payouts, too - low-price competition has already forced Telefonica to axe its dividend and Dutch telecoms company KPN has had a dramatic rethink. It's not about who pays the most, either, as we will find out.

Investing overseas offers choice, too. After screening major markets for stocks yielding between 4 and 6 per cent with cover of at least 1.5 times earnings, just 21 were listed in London. But, before we whisk you off, it's worth looking at what's available on our own doorstep. The latest Dividend Monitor from Capita Registrars reveals British companies paid out more in dividends during the second quarter than ever before. Strip out special payouts from big hitters such as Old Mutual and GlaxoSmithKline and FTSE 100 dividends still grew over 14 per cent, and in real terms payouts should soon barge past their pre-crisis peak in 2008.

That's all well and good, but Capita admits this year's specials will tame dividend growth in 2013. "We are more cautious on 2013 mainly because it is hard to see the magnitude of special payments being repeated, leaving regular dividends to do the heavy lifting," says the boss of Capita Registrars, Charles Cryer.

There are fears, too, that a dive in economic activity could force more excess cash back into businesses and away from shareholders. That said, cash piles are a big red flag, says Luke Stellini, global equities product director at Invesco Perpetual, especially given the increased likelihood of value destructive acquisitions. Indeed, talk that AstraZeneca was cutting the dividend to bankroll a spending spree was quickly nipped in the bud, but clearly this is a worry. So how sustainable are dividends, both here and abroad?

AstraZeneca rumoured to be cutting dividend.

Sustainability

"Payout ratios are still quite low by historic standards," explains Mark Whitehead who runs the International Equity Income Fund at investment manager Sarasin - the MSCI World payout ratio is currently less than the average since 1996 of about 44 per cent. "Of course, management teams are reticent about large payouts to shareholders and spending capex to drive growth when economies are on a fiscal cliff.

"That said, corporate balance sheets are in rude health, particularly in the US, and much stronger than they were five years ago," he adds. Clearly, companies will pay out dividends unless they run into trouble, but even if they do, Mr Whitehead doubts that cuts will be anything like the 15-20 per cent seen in 2008: "maybe 5 per cent in Europe if things get any worse, but it won't be across the board".

And they shouldn't be, either. If a company has its balance sheet in good shape, is paying down debt and investing for growth, it's reasonable to assume earnings are improving and that free cash flow will drive dividend growth, irrespective of where it's domiciled. Yet the hunt for equity income requires digging. A quick glance at the world equity income league table (S&P Capital IQ) reveals the FTSE 100, currently yielding around 4 per cent, is somewhere near the top, just pipping the Euro Stoxx 600 - that kind of return and a reasonable payout ratio make the UK, Germany and Switzerland Europe's "income sweet-spot", reckon analysts at S&P Capital IQ. They are, and it's no coincidence that the same powerful and persuasive institutions crop up on share registers across the region.

Over the pond, it's different. The S&P 500 yields just 2 per cent - not much to us, but highly significant in a historical context. Since 1962, the index has traded at less than half the rate offered by US 10-year treasury notes. Now those same government bonds return less than 1.8 per cent, yet strip out non-payers and the S&P yields 2.5 per cent. Still, not great, but focusing solely on headline rates can be misleading and result in investors missing out on some great deals. Conversely, look at Spain. There, the estimated yield for 2013 is a tantalising 6.5 per cent, easily the highest of the major economies, but the payout ratio is a whopping 150 per cent. There's no way they'll do that, never mind dividend growth.

"Dividends remain hot," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "More S&P 500 issues are paying a dividend than at any time since December 1999" - a tenth yield between 4 and 6 per cent. Of those, eight - including oil giant ConocoPhillips, printer maker Lexmark and defence titan Lockheed Martin - have the dividend covered at least twice. Relax that to 1.5 times and there are 20 stocks to choose from. Seagate Technology looks interesting. Its shares have doubled in value in the past 12 months, yet still trade on just 4.5 times earnings and yield over 4 per cent. What's more, despite predictions that hard-disk drives are on the way out, demand remains strong and the dividend looks like it will keep increasing.

Remember, too, that the S&P 500 is paying out just 32 per cent of earnings - historically, it's more than half - so, clearly, there's room for more.

Diversification

Overseas income generators also add valuable diversification to any portfolio. Over here, the top 10 dividend payers - think BP, Shell and Vodafone - account for almost half the total dividend return for the FTSE All-Share. Every UK-centric income fund will have them.

It's a different story abroad. Mr Whitehead's fund uses the MSCI World Equity Index as its benchmark. In it, there are 1,700 companies and over 400 yield more than 4 per cent. It's a far bigger pool of stocks to choose from and from more regions, too. It's a thematic fund that looks for long-term growth trends that produce alpha - dietary change, agriculture and Asian defence spending," he says. Clearly, companies are investing in these trends, which carry greater earnings potential and, therefore, dividend potential. "Running a global fund means we can follow those trends. It's not as easy to do that in the UK and it can limit your options."

You don't have to buy Vodafone, either. Check out MTN, says Mr Whitehead. He reckons the sub-Saharan Africa telco has shown balance sheet discipline, is generating strong returns, generating good free cash flow and is wedded to a dividend policy. True, it currently pays out less than 3 per cent, but it is committed to growing the dividend aggressively, and that growth is much more important than chasing the highest yield.

Indeed, headline-grabbing yields carry an obvious health warning and tend to scream 'distress'. Randomly plucking stocks from the top dozen yielders in our screen backs that up. Tasmanian miner Grange Resources, yielding 13 per cent with strong cover, has just cut its dividend in response to a slump in iron ore prices. Japan's Kansai Electric Power will miss its half-year payout, too, for the first time since 1980, and will France Telecom still yield 13 per cent in 2013? Non!

Research carried out for BlackRock found that, since 1976, less than half the stocks with double-digit yields actually paid out the full amount. The best risk-adjusted returns are found outside the top 10 per cent of yielding stocks, in the second and third deciles. According to research by Sarasin, even a company paying between 5 and 6 per cent has a more than 50 per cent chance of missing earnings estimates and putting the dividend under pressure. The case for the usual fundamental analysis, then, is obvious. And, clearly, the compounding effect of year-on-year dividend growth provides far more credibility, too. Just look at British American Tobacco - it yields 4 per cent and has increased the distribution by 17 per cent for the past five years. And check out Finnish elevator and escalator company Kone, says BlackRock. Rapid dividend growth has doubled the payout to investors in a little over three years.

To see how seriously American investors take this dependability, look at the S&P 500 dividend aristocrats index. Every one of its 51 constituents - including big names such as McGraw-Hill (2 per cent) and Walgreen (3 per cent), and less well-known companies such as Leggett & Platt (5 per cent) - has increased its annual dividend for at least the past 25 years - that's one sure-fire way to stay ahead of inflation. No wonder the index is at an all-time high, but demand won't ease up until rates rise elsewhere.

Growing commitment in the east

Shifting capital off to the other side of the world can be daunting. There, the Tiger economies of Asia have historically offered growth and volatility in equal measure, but not income, and buying western companies such as Coca-cola (2.7 per cent) and Heinz (3.7 per cent) selling aggressively into emerging markets has made more sense. Income stalwarts such as Roche (3.9 per cent yield and 1.5x cover) and Novartis (4 per cent yield and 1.4x cover) have a track record negotiating recessions, too. So, why go elsewhere? A casual glance at GDP forecasts gives us the answer. According to the IMF, emerging markets will grow 5.6 per cent in 2012 compared with just 1.4 per cent for advanced economies. More are paying dividends, too.

Jason Pidcock, in charge of the Newton Asian Income fund, is a standard bearer for the sector. The fund, which excludes Japan, has been running for seven years and now covers 12 markets. "There's definitely a commitment to paying dividends in Asia," says Mr Pidcock - the payout ratio has been around 40 per cent of net earnings for the past 10 years and is in line with the global average. "They generally have lower levels of debt than the west, too. And, as it's a higher growth area, total return should continue to outstrip UK-focused income funds." Analysts at S&P Capital IQ agree: "We see plenty of room for future emerging market income growth," they say. Consensus forecasts are for a 10 per cent increase in 2013, equivalent to a yield of 3.3 per cent.

It hasn't always been the case. There's been a sea change in attitudes to dividends in emerging markets over the past 10 to 15 years, set in motion by the Asian financial crisis of the late-1990s. Families still with large stakes in their businesses lost a fortune. Avoiding a repeat meant diversifying, and dividends were the best way of getting cash out of the company and into other assets such as property. "It's been a virtuous circle," says Mr Pidcock. "Return on equity is higher at these companies as they are re-rated, which keeps payouts high."

Two stocks that Mr Pidcock holds are Philippines Long Distance Telecom (PLDT) and Tesco Lotus Retail Growth Freehold and Property fund (TLGF). PLDT is the leading telecoms operator in the Philippines and Mr Pidcock likes its strong barriers to entry. He thinks earnings will be driven by increasing take-up of broadband and use of data. It trades at 15 times PE and the forward yield on consensus estimates for 2013 is 6.6 per cent. TLGF is a Thai property fund with a portfolio of 17 Tesco Lotus-anchored malls "which gives us exposure to the favourable dynamics of the Thai economy, with dividend growth tied to earnings growth of the retailers in the mall". The stock currently has a yield of 5.2 per cent.

Of course, dividends are also a perfect revenue stream for politicians keen to extract cash from state-linked companies. China, Malaysia and Singapore are particularly adept at this, but it works for investors, too. Mr Pidcock is a big fan of Thailand, where the crisis began, and the Philippines. He's cautious on China right now, but thinks Australia looks promising (26 per cent of the Newton fund is parked there).

The ASX 200 yields 4.9 per cent, but Newton's Australia plays yield even more; it owns toll-road operator Transurban (5 per cent), telecoms giant Telstra (7.3 per cent) and Sydney airport (6.7 per cent). Interest rates in Australia are 3.25 per cent and that higher risk-free rate means investors there demand more from equities.

Opportunities across emerging markets are so good that Mr Pidcock launched the Newton Emerging Income fund this week. "We believe there is enough commitment in emerging markets now and think the timing is optimal," he says. The fund will yield 4 per cent to start with and pay quarterly dividends. And, with the FTSE All-World Emerging Index currently yielding 3.2 per cent and trading on a PE ratio of 13, it's not particularly expensive, either.

Dividend renaissance in IT

The US tech sector is undergoing something of a renaissance. Information technology may not be a structural yielding sector, and historically it’s where investors have gone for growth, not income. But there's oodles of cash sloshing around in the tech space and it’s finally waking up to dividend growth.

"It may still have a higher beta than other dividend issues, but it is a player, and the dividends need to be incorporated into the total return risk-reward formula," says S&P's Howard Silverblatt.

Intel has grown its payout by 10 per cent a year for the past five years and is currently yielding just under 4 per cent. It also has a commitment to share buy-backs and future dividend payments and is not expensive, either. It trades on less than 10 times forward earnings and there's excitement over the upcoming launch of Microsoft software and upcycle in IT spend. It’s well-positioned for growth in the tablet market, too.

A superior product cycle convinced Mr Whitehead to switch out of IBM into Microsoft six months ago. Bill Gates' baby yields just under 3 per cent after raising the dividend by 25 per cent. And there's a commitment here, so expect more. And Apple has just paid out nearly $2.5bn (£1.5bn), its first dividend since 1995; about time, too. Free cash flow is phenomenal and sitting on a $117bn cash pile is criminal, so expect $45bn to go on dividends and share buy-backs over the next three years.

Yes, the US structurally yields less than the UK and Europe, but overseas equity income funds have no trouble finding quality companies paying out 4 per cent or more. It also means you can avoid those ex-growth stocks - like Telefonica, KPN, Telecom Italia and Vivendi - where there's also a big question mark over sustainability of payouts.

Instead, look for improving margins, which should mean stronger free-cash-flow generation. It's a tactic that worked well for Sarasin even when earnings were tumbling in 2009.

Big payers from around the world