Any long-term investor should be a dividend investor, notes Lynn Strongin Dodds. But the rules of the game are changing

After several years in the wilderness, high yield equity has reappeared on the institutional radar screen. These investments might not be the most glamorous but in today’s environment of volatility and low interest rates they offer the promise of steady and consistent returns. The trick, of course, is to select the right companies.

One of the main reasons why high yield income equities - those that distribute higher than average dividends - are catching the attention of institutional investors is that for the first time in over 50 years, the yield from benchmark government bonds is lower than the yield from companies. In fact, at the end of the summer, UK 10-year yields fell to a record low of 2.84%, US Treasuries hit 2.5% and German Bunds dropped to 2.09%. A significant number of companies now boast dividend yields higher than the rates they are paying on their debt.

“There are four major concerns in the marketplace,” explains Tom Elliott, strategist at JP Morgan Asset Management. “The US possibly heading into a double-digit recession; the euro-zone sovereign debt crisis; the impact of regulation; and whether Chinese policymakers will tighten monetary policy due to inflation. There are also fears that stiffer bank capital regulations may hinder credit growth growth and hence the pace of economic recovery.”

Elliott adds that although equities are considered a risky asset, “stepping back, the fundamentals behind equities do not look too bad”. He points out that in many cases, corporate balance sheets and earnings look strong, companies are paying dividends, and valuations as well as yields look good against the bond yields.

“There is an extraordinary anomaly in the financial markets today,” notes Richard Turnill, manager of BlackRock’s Global Equities fund. “If investors want to buy yield in the bond markets they have to buy lower quality assets - but we have the opposite situation in equities. Institutions now have the opportunity to invest in the highest quality businesses at reasonable prices, plus they are also getting an inflation hedge. This is why I think there is such a compelling structural case today for dividends.”

Sonja Schemmann, manager of Schroders’ Global Equity Income fund, agrees. “Looking at high yield equities in context they are attractive relative to other asset classes,” she says.

Market participants do advocate a long-term view, however. While dividend yields do not always look attractive over the short term - for example, dividend yields on the S&P Europe 350 plummeted 53% between February 2009 and June 2010 - the picture is different over the longer term. John Velis, head of capital markets, EMEA at Russell Investments, notes that that investors should be aware that dividends and dividend growth, not capital gains, drive the performance of stock markets over several years.

“I am a strong believer that if investors hold equities long term they will be able to take advantage of the profits the companies generate because they are returned to shareholders in the form of dividends,” he says. “History shows that stock prices only rise if the market believes that dividends will rise.”

Take the US equity market between 1937 and 2009. According to industry research, on average, equities returned nearly 16% per annum over each 10-year holding period, or an 11.5% annualised real return. The rate of return accounted for by real price appreciation was a mere 1.9% - less than one-eighth of the total real return. The bulk of returns were accounted for by dividend income (4.1%) and the average annual growth rate in those payments (5.5%). Data for the UK’s FTSE-All Share (from 1962 through 2009) exhibit a similar trend. Of the 13.1% annualised return over that period, 7.1% is due to inflation and just 1.1% to price appreciation. The remaining 4.9% is attributable to a combination of dividend income and dividend growth.

Although the arguments for high yield equity look strong, not every company qualifies. Typically, less cyclical sectors such as oil and gas, telecoms, consumer staples and healthcare sectors have been the most popular dividend plays. These companies have traditionally been the most generous in terms of dividend payments on the back of secure cash flows.

For example, UK supermarket heavyweight Tesco raised its dividend by 9.1% last year, from 11.96p per share to 13.05p, in line with its earnings growth. Royal Dutch Shell which, along with its peers, has had a turbulent year, increased its dividend by 4.69% and boasts average annual dividend-per-share growth of 11.7% over the past five years. France Telecom has a dividend yield of about 8%, compared with its 10-year bond, which yields 3.2%.

“The focus is on defensive stocks which will continue to grow in an economic downturn. This is why these sectors have historically been chosen,” says Schemmann. “However, we look for individual companies that have strong management teams and earnings growth.”

Turnill echoes these sentiments. “It is not just about the yield but about the yield and dividend growth,” he says. “Companies need strong balance sheets and a sustainable business model to ensure that they will continue to make the dividend payments. We look at companies across a diverse range of sectors and regions.”

Ben Fischer, managing director at NFJ Investment Group, part of Allianz Global Investors, is also an advocate of a diversified portfolio of high yield income stocks. “Investors should be looking at high-yielding and high-quality companies that are relatively inexpensive,” he suggests. “For example, Johnson & Johnson is sitting on a P/E ratio of 12 and dividend yield of 3.5%, while Pfizer is on 7.8 times with a 4% yield. Both are attractive relative to 10-year Treasuries.”

Investors should be aware that the past is not always an indication of future dividend payments, as the example of BP demonstrates. The suspension of the oil giant’s dividend, and its plans to sell $10bn (€8bn) of assets and cut capital expenditure in the wake of the Gulf of Mexico oil rig crisis, has certainly hit income investors who had come to rely on their dividend cheques. The National Association of Pension Funds (NAPF) estimates that BP stock accounts for around 1.5% of a typical UK pension fund portfolio and, before the crisis at least, around 6% of the dividend income from the FTSE 100.

Many banks also disappointed investors in the wake of the financial crisis and more recently during the sovereign debt debacle with unprecedented dividend cuts. However, according to research from Barclays Capital, dividends from European banks could “lift off” after key parts of new capital rules were clarified, with SEB, Swedbank and UniCredit, UBS, Société Générale, BNP Paribas, HSBC, Standard Chartered and BBVA among those set for positive surprises. Instead of conserving capital, as has been the recent practice, clarification of the Basel III capital rules should result in some banks deploying surplus capital. The research stated: “In the four years pre-crisis, the sector paid dividends of €131bn, yet only generated free cash flow of €52bn. Over the next four years, we estimate free cash flows of €213bn and dividends of €107bn.”

Some of the old certainties of dividend investing have been rocked by the financial crisis. But for investors in it for the long term, the fundamentals remain difficult to dispute and the opportunities potentially much more rewarding.