Stocks have paid a heavy price for the economic turmoil that has ravaged London markets during the second half of this year but it hasn’t all been bad news. A direct consequence of depressed market caps is that those companies that continue to pay dividends look all the more attractive. Indeed, for investors chasing income, the conditions have provided an ideal hunting ground for buying into some of the best dividend payers in the market – but how do you find them?
Screening for high yielding stocks is nothing new; in the early 1990s Michael O’Higgins and John Downes popularised the approach in their book Beating the Dow. Their Dogs of the Dow technique stripped away conventional metrics such as EPS growth and PE ratios and focused simply on who was paying what. The idea was that by backing a mechanically selected basket of stalwart income generators, investors could insulate themselves from the vagaries of the market and still make a profit.
The technique involved taking the 30 stocks that make up the Dow Jones industrial average, filtering them for the 10 highest dividend yields and then investing an equal sum in each stock. The appeal of this approach is its simplicity – you simply take a company’s current annual dividend per share and divide it by the stock price. In terms of housekeeping, O’Higgins and Downes urged that the 10-strong portfolio be revised once a year based on an updated list of high yielding stocks.
With market volatility providing fewer and fewer opportunities for all but the bravest investors, a dividend screen – in this case the Dogs of the Footsie – offers an intriguing option. Scrutinising large, mature and relatively safe companies means investors can put less emphasis on market reaction and sentiment and focus more on finding attractively priced dividend payers. The screen theoretically offers a conservative option that produces a list of well financed companies that have long histories of weathering economic turmoil.
The technique has added resonance at a time when market conditions are weak but dividend levels are rising. According to Capita Registrars, the rolling historic yield for the FTSE 100 (UKX) for the four quarters up to the end of Q2 2011 was 3.4%. The forecast for the whole of 2011 is 3.6%. With a list defined using Stockopedia PRO, the top 10 stocks offer yields starting from 5.16% and rising to 9.54% - so it may be time to consider ditching the tracker fund.
Watch for the detail
Before discussing the Dogs of the FTSE screen results, it is worth noting some potential downsides. The main criticism of the technique is that an annual review of the portfolio is likely to mean making some major changes thus triggering potentially high trading costs and possibly crystallising capital gains taxes.
Another health warning is that by using this technique, investors are relying on historical dividend yields as the basis of making investment decisions. Analysts have been quick to point out that while high yields may simply point to out-of-favour stocks, those yields are susceptible to being cut. To try to deal with that, we have overlaid the Dogs of the Footsie screen with the Dogs of the Footsie Forecast screen, which means we have compared historical yields with forecast yields, but the latter in turn is reliant on analyst dividend forecasts being accurate (which - as we've discussed elsewhere - they generally aren't!). Interestingly, eight of the 10 companies – all of them FTSE 100 stocks – appear on both screens.
The first of them is Royal & Sun Alliance Insurance (LON:RSA) which, with a current dividend yield of 8.09% is among a number of financial giants on the list, including fellow insurers Man Group (LON:EMG), Aviva (LON:AV.) and Standard Life (LON:SL.). Shares in RSA reached a 12 month high of 135p in May but the stock has since fallen to around 108p. Nevertheless, the full year dividend was increased by 7% to 5.70p, reflecting what CEO Andy Haste said was the company’s confidence about its outlook. 2010 was a difficult year for insurers generally, with higher than normal weather-related losses. RSA has insisted that a focus on emerging markets, where it is already seeing double digit growth, will prove to be a key factor in its future performance.
Meanwhile, BAE Systems (LON:BA.) is the only industrials business on the list, with a current dividend yield of 6.35% helped by a share price that has slipped from 340p to 277p since January. BAE increased its total dividend by 9.4% to 17.5p in 2010 despite concerns about a slowdown in sales at its Land & Armaments division caused by pressures on defence budgets, particularly in the US and UK.
For energy company National Grid (LON:NG.), last year proved to be a strong one, with pre-tax profits up by 25% to £2.5bn contributing to an 8% rise in the dividend to 36.37p – in line with its policy of targeting 8% growth until March 2012. National Grid’s obligations to engage with regulatory changes in its UK and US businesses and upgrade gas and electricity supply infrastructure saw it spend £3.6bn on capital investment last year. Shares in the group have risen from 515p to 601p in 12 months, meaning that the current yield stands at 6.02%.
Elsewhere, Astrazeneca (LON:AZN) is the only pharmaceuticals group to make it onto the Dogs of the FTSE list, although 2011 will probably be a year to forget for both the company and its investors. Shares in group have hurtled between 3126p and 2595p this year but its current price of 2942p is largely where it was 12 months ago. News from the company has been mixed but it remains of major interest to investors – qualifying for nine value, quality and income stock screens on Stockopedia PRO. Last year the company increased its dividend by 11% to 161.6p – representing a current yield of 5.57%. Overall cash distributions to shareholders through dividends totalled £2.2 billion.
Next, real estate group British Land (LON:BLND) scrapes into the Dogs of the FTSE list with a current yield of 5.16% on a dividend that was maintained last year at 26p. Macro economic woes have been tough on British Land’s retail business of late but the Central London office market has been more robust. Shares in the company have been volatile this year, reaching a high of 614p in July but currently trading at 490p. The stock lost 59p during two weeks in November but then went on to claw most of that back during the following five days.
Finally, depending on which day you look, telecoms giant Vodafone (LON:VOD) sits just on the edge of the Dogs of the FTSE list with a current yield of 5.14% after increasing its dividend last year by 7.1% to 8.90p. Shares in Vodafone have traded in a fairly narrow range of between 155p and 166p through most of 2011 but have recently managed to break through 170p. Exceptional dividend payments due next year following a maiden pay-out from its part-owned US arm Verizon, skew Vodafone’s yield forecasts. However, the company has said that it expects that total dividends per share will be no less than 10.18p for the 2013 financial year.
As ever, a screen like this is just the starting point for further research. All of the stocks highlighted here have Piotroski F-Scores of between four and six out of a possible nine – so nothing spectacular but putting them in the mid-range on a scale that measures the health of potential value investments. In terms of dividend cover, which is the ratio of a company’s net income over its dividend and which can indicate how sustainable a dividend actually is, the findings are more mixed. Dividend cover of less than 1.5x may indicate a danger of a dividend cut while more than 2x is usually viewed as healthy. All these companies have cover between 1.65x and 3.66x (except RSA where it has been falling for four years and currently stands at 1.1x). Finally, BAE Systems is the only company where there appears to be a possible red flag according to the Altman Z-Score. As bizarre as it may sound for what is widely seen as a defensive play, BAE looks to have an Altman score below 1.8 meaning that some aspects of BAE’s financials resemble those of companies that have gone under. Then again, the Altman Z-Score does also produce false positives, so this may be the case here.
For dividend hunters, the Dogs of the FTSE screen offers an interesting starting point for selecting hitherto reliable income generators that are well used to fending off market volatility. The advantage of applying the screen in the current climate is that investors are not only buying into dividends but they are also acquiring attractively priced blue chip stocks that are likely to enjoy capital gains when market conditions begin to improve. However, even with the addition of the forecast yields screen, the uncertainty surrounding the eurozone and the prospect of another UK recession means investors would be well advised to approach the results with care. We will be tracking the screen's performance on Stockopedia PRO!
Of course, we'd welcome thoughts & views on this strategy using the comment box below. As a reminder, you can sign up for the Stockopedia PRO beta site!