Boost your income – the top dividend paying shares to watch

29th May 2014


Do you live in a home that now has two post deliveries some days? If so, you probably think you are better off. But don’t be so sure of that if you hold Royal Mail shares writes Tony Levene.

The additional delivery comes from those orange coloured posties who work for TNT, the Dutch owned mail group which now puts envelopes through doors in some areas.

This is visible – and acknowledged – competition for Royal Mail which had a controversial flotation last October at 330p per share.

And the uncertainty of rivalry from TNT, and others in the parcel space, could undo the hopes of Royal Mail income seekers as well as those currently sitting on a tidy capital gain.

There’s an enormous investor appetite for equity income shares which pay reasonable dividends as well as offering the prospects of some capital growth (although with risk of capital loss).

And demand for income producing shares can only rise when a likely torrent of cash hits star fund manager Neil Woodford’s new equity income fund which starts life on June 2 – his cheerleaders will be disappointed if he does not have several billions to play with. That’s on top of the record £500m net investment in April into the equity income sector. Woodford is aiming at a 4% dividend return plus some capital appreciation. The average FTSE100 company pays around 3.5% – some three times more than cash in savings accounts.

UK dividends – the state of play

Royal Mail will not have an official yield figure until it completes a full year. But following 13.3p per share to be paid on July 31, it looks as though it is heading for a yield of just over 4% at the current 525p share price – down from the 618p high but still well ahead of the 330p IPO tag.

But now that the market has cottoned on to the competition, Royal Mail is vulnerable. Investors may want higher dividend yields to compensate for trading doubts – and that involves either the share price falling and the dividend staying static or the dividend rising. The company said its dividend policy will be in line with earnings. It needs to re-invest so it can’t be too generous but, equally, it knows that if the payout dropped substantially, the share price would crack.

Around 25 shares in the top 100 pay more than 4% – and it is this index, accounting for 80% of the London market’s valuation, which contains the vast majority of income stocks. Small companies reinvest their profits but more mature situations tend to generate more in earnings than they need – so they reward their shareholders.

Income investors – whether individuals or fund managers – have an ideal. They want a company which promises increasing dividends year on year backed by growing profits. They seek dependability.

READ MORE: TSB and the long wait for dividends

They don’t want shocks – fallen income favourites include Royal Bank of Scotland and Lloyds, both off the dividend lists since the banking crisis. But there is always hope. Lloyds could return to payouts next year or the one after while although BP slashed its dividend following the Gulf of Mexico disaster, it has since clawed its way back to the higher end of the payout list.

Nor do they want “uncovered” dividends. To find the dividend cover, divide net earnings by the total payout cost (or divide earnings per share by dividends per share – it’s the same). If a company has taxed profits amounting to £500m and its dividend cost is £100m, the dividend is covered five times, allowing substantial re-investment. Another way of expressing this is the “payout ratio” – this company would have one of 20%. Large companies typically cover their dividends around 1.5 times to twice – HSBC with a yield of 4.4% has a 55% payout ratio is typical. Cover can go negative when companies dip into reserves to pay dividends – often a danger signal.

A generous dividend is not necessarily a good sign. It can be historic, based on last year’s earnings while the current and future years look like a problem – many of the mining and natural resources companies in the FTSE100 fall into this category. Investors can base decisions on yield forecasts going forward.

High payout ratios (or low dividend cover) give little protection against the unexpected with many investors taking any yield more than a third higher than the average with caution. A high yield can suggest a company that has run out of steam or, worse, of profits. Take Morrison Supermarkets as an example – it has warned on profits and trading. It yields around 6% but that may not be enough to cushion investors against the future.

READ MORE: UK dividends soar to an unprecedented £31bn

GlaxoSmithKline only covers its 4.8% yield around 1.25 times suggesting a company which has seen its best growth in the past – plus it faces bribery allegations in China and elsewhere. And Admiral barely covers its 3.4% yield, offering little scope for regular increases.

But sometimes a zero yield can be confusing. Rolls-Royce shows no dividends but it pays “C” shares which can be converted into new ordinary shares to compensate – these have tax advantages.

According to Morningstar, the leading shares held in equity income funds are BT, Vodafone, AstraZeneca, Royal Dutch Shell, British American Tobacco and BP.

Tips from income fund managers

Dig deeper than dividend cover is the advice from George Godber, of the Miton UK Value Opportunities fund. Profits can be manipulated and over-stated, sometimes with accounting sleight of hand. Godber prefers to look at how much actual cash a company has generated over the year after it has has paid every bill, including debt interest and dividends – the “retained earnings” theory favoured by Warren Buffett .

Jan Luthman, at Liontrust is not keen on companies which borrow to pay dividends. “Paying dividends from debt is something I’d normally associate with deep recession – housebuilders have done this at times, for example,” he said. “When it happens, it rings alarm bells.”

Matt Hudson of the Schroder UK Alpha Income fund is not scared of zero yields. “I look for stocks that can deliver really good capital returns as well. And that’s quite often in the recovery phase of the market to the point when you might own stocks with low or even zero yields.”

Adam Avigdori, manager of the BlackRock UK Income fund sees media giant Reed Elsevier and instrumentation specialist Spectris as among the safest dividend payers. Reed yields a 2.5 times covered 3% and is expected to grow ahead of inflation into foreseeable future. At 1.8%, Spectris suits his book thanks to double digit dividend growth each year since 2009.

Carl Stick, who manages Rathbone’s Income fund, is a fan of defence and aerospace firms such as BAE Systems which returns 4.4%. These are cash-generative businesses with solid long term government contracts.

James Henderson, at Lowland and Henderson Opportunities investment trusts, goes for insurer Hiscox, speciality chemical firm Elementis, and loans company Provident Financial as his safest dividend payers.

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