Dividend investing: top tips from the experts

Investors who are struggling to secure sufficient income from cash or bonds are increasingly turning to equities as the best way to generate a regular pay-out from their capital.

Dividend payments from listed companies have been improving on the back of improving earnings – but the holy grail of income investing is finding companies with plenty of cash on their balance sheets and strong growth prospects in both a bull and a bear market. However, finding stocks that pay consistently rising dividends is not easy.

So, FT Money asked professional income investors for their tips on what to look for – and what to do if dividends disappoint.

1. Look for companies that will be able to grow their dividends over time

Kevin Murphy, co-manager of the Schroder Income fund, says that investors should focus on cash flow in a company, as that is what ultimately finances the dividend. “When you have an attractive dividend that is well covered by cash, that gives you flexibility,” he says. “And that allows you to grow the dividend over time.”

Gervais Williams, who runs the MAM Equity Income investment trust, says it is crucial to check the balance sheet, as a company with limited cash could cut its dividend and then, worse still, tap up shareholders for more money in a rights issue – as the banks did during the financial crisis.

But don’t just look for dividend growth. Stuart Rhodes, manager of M&G’s Global Dividend fund, says it is important to find stocks on below average valuations. Buying the best dividend payers, such as Nestlé or Coca Cola, when markets were shaky at the start of 2009 would have meant paying three or four times as much as other businesses, Rhodes points out.

2. Don’t be tempted in by the highest yielders

“You should have your eyes wide open if something has a big yield,” says Williams. “You’re already in a position where the market is perhaps assuming that the dividend isn’t sustainable.”

Nick Raynor, investment adviser at The Share Centre, points out that some of the highest yielding stocks may not have sustainable dividends. Thomas Cook, for example, is currently yielding 15 per cent, while Home Retail Group is yielding 10 per cent. But Raynor doesn’t expect either company to have such a high yield next year. “That’s what we always highlight to our investors: the yields you see on the internet are historic. It’s what they have paid out – not what they are going to,” he points out.

3. If a company cuts its dividend, don’t sell it straight away

“The most natural reaction when a company says it won’t pay a dividend is to sell it,” says Rhodes. “The problem with that is you’re usually locking in a pretty sizeable capital loss.”

He recommends waiting for a 6-9 month period on average after a company has cut its dividend, to give the share price time to recover.

Not all income investors sell stocks that don’t pay a dividend. Murphy says he sometimes holds on to such companies because the shares are likely to be cheap. He still holds dividend-cutters including Taylor Wimpey and Dixons, both of which he believes will start paying an income again soon.

4. Widen your search outside the UK

“The UK is like the England football team,” says Rhodes. “It’s quite good, but it’s not the best.”

Only a handful of companies in the FTSE 100 are consistent dividend payers, which means that if something goes wrong – such as when BP cut its dividend last year – UK equity income funds can struggle.

“Taking the parochial step to invest solely in UK equity income funds means you miss out on a huge volume of global high yielders,” says Brian Dennehy of Dennehy Weller & Co. He believes that investors will increasingly turn to Asia for dividend growth, predicting: “By the end of this decade, one of the biggest surprises will be the extent to which UK pensioners rely on Asian companies for a growing income.”

Next week, the Securities Trust of Scotland will become the first equity income investment trust to have a global mandate. “I think investors want choice,” says Alan Porter, the new manager of the trust at Martin Currie. The trust will look for stocks listed on the MSCI World High Dividend Yield index, which currently yields 4.8 per cent.

However, fund managers warn that it can be much more work to sift through companies in emerging markets, as they may have less well-developed corporate governance and may not be committed to paying a dividend. Rhodes’ M&G fund, for example, has nearly 40 per cent of its holdings in the US and Canada, 14 per cent in the UK, and just 10 per cent in Asia ex Japan. One exception, says Rhodes, is Brazil, which requires companies to pay out at least a quarter of their earnings as dividends, and where he has nearly 8 per cent of his holdings.

5. Diversify across different sectors

“For investors to concentrate their investment on individual shareholdings, or a small selection, is dangerous,” says Dennehy. “Many discovered this to their cost when the banks stopped paying dividends: these were widely held by private investors who thought big companies are safe dividend payers.”

This approach can also be applied to income funds. Dennehy recommends buying a mix of income funds. Some, such as Schroder Income and M&G Global Dividend, have lower starting yields but are more likely to grow them. Others, such as Newton Higher Income and Artemis Income, have higher starting yields but less growth potential.

Porter says that income investors often stick to defensive stocks and avoid cyclicals – companies whose earnings fall during a recession. But this could mean you lose out on some growth, he says, as cyclical stocks are often cheaper when the economy looks shaky.

Murphy also recommends checking out sectors such as banks and retailers, which are not paying dividends but are likely to do so in the future – offering investors the opportunity to buy the shares while they are cheap.