Published 20 January 2010
When I first started working on the investment side of finance 30 years ago many of our clients looking for returns from the equity markets focused almost entirely on dividends as opposed to the share price. In fact it is fair to say that they looked upon capital growth as a very welcome by-product of the earnings growth they sought.
This approach had significant merit for many reasons. Earnings growth and the resultant increase in dividends tended to be far more consistent than the volatile capital growth you associate with the stock market. In the vast majority of cases I would argue that the capital growth is simply a function of the earnings growth. When it is not, any significant rise in the share price is rarely sustainable.
This latter point was clearly demonstrated during the dot.com boom when some internet companies, which had never seen a profit and had turnovers in line with the average English pub, achieved market valuations far above their status. This unsustainable position led to the subsequent crash in early 2000 and the downturn in the market which continued until the spring of 2003.
The cult of the "high dividend share" was well established long before 1991, but it was in this year in his book "Beating the Dow" that Michael O'Higgins converted it into an investment strategy which became known as "the Dogs of the Dow". In this publication he advocated investing each year in the top 10 yielding shares in the DJIA, the Dow Jones Industrial Average Index, which comprises the 30 largest companies in the USA. Many of these offered high yields because of recent underperformance hence the term "dog" applied.
Many people feel one of greatest attributes of this strategy is its simplicity – backed up with sound performance. For example from 1972 to 2008 returns would have averaged 12.6% a year beating the Dow (about 10%) (source: Michael O’Higgins as quoted in money.cnn.com*). However in recent years any "dog" follower would have been barking up the wrong tree. In the last three years the "dogs" have lost money and underperformed due to the high proportion of financial stocks that made up the "pack". Such stocks have, as you would expect, badly underperformed in the recent financial crisis. However some commentators feel that 2010 will see a resurgence in the relative performance of the high dividend share. Although the performance quoted above is based on America and the theory has US origins there is obviously a strong correlation with their “canine cousins” in the UK.
Despite its recent underperformance there is some sound investment logic why such a policy is one that should be given consideration by the long term investor. There are basically three reasons why this is the case:
1) A high dividend can sometimes be a sign that a stock has been oversold. The negative correlation between price and yield can mean that a stock which currently offers a high yield is cheap and has the capacity to recover.
2) The willingness of the board to release a significant amount of profit in the form of a dividend to the shareholders, as opposed to retaining it in the business, can be viewed as a vote of confidence by the directors in the current financial status and future prospects of the company.
3) The Barclays Equity and Gilt Study and other works have confirmed the importance of the reinvested dividend when it comes to the long term performance of shares. In the long term it can make up a surprisingly significant proportion of the overall return. The larger the dividend the greater the potential impact.
At this point let me distinguish between some of the key terms. Earnings per share (EPS) is the profit allocated to shareholders - so the earnings yield is calculated by dividing this figure into the current share price, the higher this figure the better. The dividend is the amount of these earnings that will be paid to shareholders (some will be retained in the business to fund expansion, provide liquidity etc). You would therefore calculate the dividend yield by dividing the total dividends paid during the year into the share price. The relationship between the earnings per share and the dividend per share is referred to as the "cover".
If for example the dividend per share is 25p and the earnings per share 50p, then the dividend has “cover” of 2. It tells you how many times the dividend could be paid out of current years profits. Once again the higher the cover the better, as it clearly provides a view on the dividends sustainability (for more detailed worked examples see my article on Yield calculations from February 2009). You can find the dividend cover figure quoted on the research pages for each stock where applicable (see directions below).
If the “dogs” theory appeals then I think the best way to provide a sample of shares to select from is using the "advanced stock selector" (see directions below).
The first field I would set would be the "market cap". A minimum setting of £1bln could be used (a setting of ‘1,000’ as the measurement is in millions). This would restrict the search at the time of writing to the top 180 companies quoted in the UK. This is relevant as consistent dividends tend to be a feature of larger companies, after all the Dow is a blue chip index measuring the top 30 companies in the US. If you wanted to restrict your search to a similar number of companies then you would move the minimum marker to £10bln (‘10,000’). The next criteria I would use to further refine my search would be a minimum dividend yield of 3.5% (roughly in line with 10 year gilt rates which is often used as a yardstick to measure the "high dividend level"). I would also set the minimum dividend growth to 5% over 1 year - if companies have maintained growth through this difficult period, it is a good sign. Finally, I would set a minimum broker rating of 4, equivalent to a "hold" or better. Such a search using a £10bln market cap produces at the time of writing 11 stocks which could qualify as the “UK dogs of the FTSE”. Have a look at the present “pack” and see which ones appeal**.
If the “dog” theory is of interest but you prefer to make a single investment in high-yielding stocks, then you might wish to consider the iShares FTSE UK Dividend Plus (IUKD) which invests in approximately 50 of the highest dividend paying UK stocks from the top 250 UK stocks. So not all blue chips and pedigrees! If you look at the chart for this fund over the last four years you will see the underperformance of such shares clearly shown from mid 2007 to March 2009. However in the longer term this strategy may be attractive - after all every dog has his day, so 2010 and indeed the second decade of the millennium may well see the comeback of Michael O'Higgins theory!
Remember though, that no matter what theory you follow, when you invest you can lose as well as gain.
To view a chart of the iShares FTSE UK Dividend Plus visit the iShares website and enter IUKD into the search box.
Good luck with your investing!
You will find the 2009 version of this study in the Research Centre.
1.Login, selecting the Research tab
2.Within the list for Barclays Wealth Insight choose Special Reports
3.The Equity Gilt Study 2009 was uploaded 1 May 2009.
You can find the dividend cover figure by logging into the website and going to the research tab.
1. Login and go to the ‘Research’ tab
2. Enter the name of the company in the search box
3. Select the ‘Financials’ sub tab
4. And the link to ‘Fundamentals’
Another useful tool is the Advanced Stock Selector which allows you to screen companies by using a combination of defined criteria which you select - a vetting tool therefore which you can personalise to your own requirements.
1. Login
2. Go to the Research Centre
3. Select the Stock Tools tab
4. Chose Stock Selector
5. Chose Build your own
*As quoted on http://money.cnn.com/2009/01/28/magazines/fortune/investing/investor_daily.fortune/index.htm
**All information correct as at 6 January 2010.
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