Forget growth, income seems to be the story of the moment.
A Merrill Lynch survey this week indicated for the second consecutive month that fund managers preferred companies to return cash to them, rather than spend it on acquisitions or new plant and equipment.
“We have had an equity community that has focused on growth investing for the last 10 years. Maybe income investing is going to be part of a new theme,“ said David Bowers, Merrill's chief investment strategist.
The best ways for companies to return cash to shareholders are through dividends - including special one-off pay-outs - and share buy-backs. It is not surprising that there is more emphasis on these at a time when company balance sheets are in reasonable shape and merger and acquisition activity is relatively subdued. Also, when markets are going sideways, dividends are an increasingly important component of total return. Indeed, in subdued markets, shares come to be seen as a sort of bond, and the ability of companies to pay a reliable (and hopefully rising) level of income is prized.
There is no doubt that there is a trend towards higher dividends. Microsoft, the classic growth company of the 1990s, is credited with triggering a turnaround in sentiment. Earlier this year it pledged to pay a staggering $32bn in a special dividend this year, as well as $44bn in buy-backs and enhanced dividends over the next four years.
In the UK, Centrica, the biggest supplier of gas and electricity, said in July that it would return £1.5bn to shareholders after agreeing the sale of the AA motoring organisation. It also pledged to lift the proportion of earnings paid out to shareholders from 32 per cent to 40 per cent in the current financial year and 50 per cent next year. Its shares have risen by 10 per cent since the announcement. “It's quite common at the moment that when a company announces a dividend increase, its share price is rewarded,“ says Andrew Milligan, Head of Global Strategy at Standard Life Investments. That's not always the case, however. Redrow, the UK housebuilder, lifted its dividend this week by 20 per cent and promised to repeat the feat for the next three years even if the housing market cooled. Its shares fell on the day of the announcement, but recovered some of the lost ground later in the week.
A significant watershed in the trend towards higher income will come if Vodafone, another classic growth stock of the 1990s, decides to increase its dividends substantially. Such a move is widely expected, with analysts wary about the company making another big acquisition and potentially overpaying for it. In the year to March 2004, the group lifted its final pay-out by 20 per cent, taking the total to 2.03p per share. But analysts are anticipating further moves. Morgan Stanley has just increased its forecast for Vodafone's dividend for its 2006 financial year to 4p a share. This would take the yield to more than 3 per cent, much nearer to the market average than the (low or non-existent) level normally associated with a fast-growing stock.
It's not just dividends that are increasing - share buy-backs are very much in fashion. Vodafone, Alliance & Leicester, AstraZeneca, Barclays, Boots, BP, BT, Dixons, Diagio and Glaxo SmithKline are among the UK companies all carrying out share buy-back programmes at the moment. Morgan Stanley estimates that UK companies will spend a record £14bn on share buybacks this year. It says this equates to a “buy-back yield“ of 1.2 per cent which, when added to a 3.4 per cent dividend yield, provides an overall effective yield of 4.6 per cent. Graham Secker, Morgan Stanley's UK Equity Strategist, say that companies that have bought back their own shares during the last eight years have “outperformed the index markedly with little differentiation based on the relative side of the buyback.“ There is a negative side to buy-backs however: they are a signal from companies that growth opportunities are limited.
What does all this mean private investors? Look for companies that have high cash levels, strong free cash flow generation and low gearing, as this gives them the capacity to lift dividends sustainably and buy back shares. The key word is sustainable - there's no point in buying a company for its yield if the dividend is promptly cut. Lloyds TSB, for example, yields almost 8 per cent, but there has long been speculation that its pay-out will be cut. Remember, too, that yields can go up because a share price has fallen, not because dividends have been increased. So buying yield is not without its risks. Having said that, if markets continue to move sideways or even go down rather than up, a good income flow is a considerable consolation.