Investors cash in on UK dividends boom

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Vodafone has boasted high dividend growth in recent years

Income-hungry investors are pouring money into dividend-paying stocks, buoyed by “unprecedented” payouts from UK companies.

Total payments by UK companies in the third quarter of this year reached £23.2bn, according to the latest dividend monitor from share registrars Capita, as cash-rich companies gave back unused money sitting on their balance sheets to shareholders.

The report said of the 226 companies that paid a dividend in the third quarter, 173 increased, started or reinstated their payments. Capita said the dividend payout for the current year should total £78.6bn, a new record, with 2013 set to top that at £81bn.

“Whereas individuals and governments continue to struggle to repair their balance sheets, quality companies did this in the wake of the financial crisis and are now reaping the rewards,” says Richard Hunter, head of equities at Hargreaves Lansdown stockbrokers.

“The excess cash they are generating – which, on the whole, they are not yet prepared to invest in technology or new people – is therefore being deployed in a number of ways.”

These include paying down company debt, maintaining or increasing dividend payments to shareholders, buying back shares or acquiring other companies.

Jane Sydenham, investment director at Rathbone Investment Management, says more investors are buying stocks with dividends because yields on both cash and bonds have fallen to all-time lows. “Against a reasonably inflationary background UK dividends have risen, so have helped investors keep up with a rise in the cost of living,” she says.

Listen to Lucy Warwick-Ching talk about the importance of dividend investing on the FT Money Show podcast

But income is not the only reason why dividends are so cherished by investors – they also dramatically increase the compound returns on investment (see box).

“The longer the investment period, the more powerful the effect of reinvesting dividends becomes,” says Iain Tait, partner at London & Capital. “In this way the dividend effect totals approximately 60 per cent of the total returns over a 20-year investment horizon.”

Traditionally, investors have focused on dividend yields – the annual dividend divided by the share price – as the key metric for choosing income stocks. But Lee Robertson, chief executive of wealth manager Investment Quorum, says successful dividend investing is not as simple as picking the highest-yielding stocks.

“Focusing solely on dividend yield can be a flawed strategy as a high yield can often be a sign of a company in trouble or with limited growth potential,” he explains.

Instead, he believes investors should focus on a company’s prospects for long-term dividend growth. “A stock with a reasonable yield and a growing dividend should, after a while, achieve a higher dividend than a high-yielding stock where the dividend is not growing,” he says.

Jason Holland at broker Bestinvest agrees. “High yields could reflect a stock price that has been downrated by the market because investors are not convinced that the dividend is sustainable,” he says. “It’s important to look at how well covered the dividend is by underlying earnings and the outlook for the business.”

Historically, he says, the most popular sectors for income investors have been the classic defensives, such as food, tobacco and utilities. But some of these companies are looking relatively expensive compared to the wider market. Shares in British American Tobacco yield 4.5 per cent, for instance, but trade on a price to earnings ratio of around 20 times, versus an average of 12 for the FTSE 100.

Analysts at Killik like Compass Group, the caterer, which yields 3.2 per cent, Vodafone on 5.8 per cent, and National Grid also on 5.8 per cent yield. Hargreaves’ favourite income stocks include life assurer Aviva, yielding 7.7 per cent, Vodafone, Shell on 4.7 per cent and United Utilities on 4.3 per cent.

For those investors not comfortable investing in single stocks one of the most common ways to benefit from dividend income is to invest in collective funds such as unit trusts or open-ended investment companies and investment trusts.

Equity income funds have been heavily promoted by platforms and providers alike. Bestinvest’s top picks are Threadneedle UK Equity Income and, for those wanting more of a blue-chip focus, Fidelity MoneyBuilder Dividend fund. AWD Chase de Vere adds Rathbone Income, yielding 4.2 per cent, and the Artemis Income fund yielding 4.5 per cent to the list of its recommended funds.

One problem for fund investors, says Gervais Williams, small-cap fund manager at MAM Funds, is that the UK is a highly concentrated market with a large proportion of dividends from a handful of megacap companies. Last year, just six companies accounted for 40 per cent of all UK dividends.

“Many of the big funds hold the same dividend-paying stocks,” he explains. “This means it is becoming a ‘crowded trade’ with everyone in the same thing. Investors are starting to expand into smaller companies to get the diversity they need.”

Another option is to look overseas, where a dividend-paying culture is now becoming more common. The US market, for instance, has 92 “dividend achievers,” says Robertson. These are companies that have increased their dividends for 25 or more consecutive years and include well-known names such as Coca-Cola, Walmart and Procter & Gamble.

Robertson adds that in Europe, companies such as Nestlé and Telefónica have good capital discipline and the potential for long-term dividend growth – although the latter cut its payout this year.