Trading Strategies: In an uncertain climate, dividends are a safe bet

A dividend is a bird in the hand. Even if you do not require income, cash received by way of a dividend can immediately be put to another good purpose and it relieves the strain of waiting for capital appreciation.

A dividend is a bird in the hand. Even if you do not require income, cash received by way of a dividend can immediately be put to another good purpose and it relieves the strain of waiting for capital appreciation.

What is less well understood is that over any five-year period, high-yielding shares are likely to out-perform the market as a whole.

One of the most famous advocates of solid dividend-paying companies was Michael O'Higgins, a US fund manager who in the early 1990s developed a system based on taking the top five yielding stocks in the Dow index, and constructing a portfolio with 20 per cent in each. He would maintain this position for a year, after which he simply repeated the process.

For the period 1991 to 1995 this strategy produced an average annual return that exceeded the index by 5 per cent, but it came unstuck during the dot.com bubble of the late 1990s. And while it worked in 2002 and 2003, it again failed miserably last year.

Assuming that a single mathematical formula in isolation can deliver the Holy Grail is hopelessly optimistic. But buying shares in high-yielding companies is an effective strategy in climates such as this one where markets are subdued, because it mimics a contrarian approach.

Put simply, a share's yield will look higher than average when the company is out of fashion and the share price has fallen, all else being equal.

Most income stocks are mature companies that have found nothing better on which to spend their money. Right now many fund managers are dumping small companies, which have enjoyed a great run since March 2003, and are switching back into these large blue chips.

The reasoning is that the FTSE 100 index of shares in Britain's largest companies is trading on a price-to-earnings ratio of around 12 compared with over 14 for the FTSE 250 index; the risk return trade-off of small, volatile companies is not worth chasing.

Certain basic, back-to-earth industries pay generous dividends. No list of great income shares is complete without banks such as Lloyds TSB, currently yielding 7.66 per cent, and Alliance & Leicester, yielding 5.83 per cent.

But the banking sector is exposed to the slowdown in consumer spending and the housing market, and companies heavily reliant on the UK mortgage market will be pulverised.

Insurance companies, however, are more difficult to call. Legal & General, Royal & Sun Alliance and Aviva (formerly Commercial Union) have recently slashed their dividends.

On the other hand, insurance company sales in the first quarter have been buoyant. Legal & General and the Prudential grew their new business by 43 per cent and 26 per cent respectively in the first three months, supported by demand for pensions.

Utilities are also great dividend plays, led by United Utilities on a yield of 7.03 per cent. Again the big question is whether their fantastic run is sustainable.

One popular indicator is "dividend cover" (the company's earnings per share divided by its dividends per share) which is a measure of how easily the company paid its dividends. For instance, dividend covers of 1.7 at National Grid Transco, Kelda and Legal & General are all attractive as they demonstrate that these companies made sufficient profits to have paid out over three quarters as much again.

But dividend cover is a flawed, backward-looking measure, based on earnings per share that represents what has already been achieved by way of profits.

For predictive value, cash flow per share is a more accurate indication of the company's ability to pay out in future. So, for example, every Legal & General share is matched by cashflow of just 6.72p, around one tenth of the average of 65.44 pence for the FTSE 350 index.

At the other extreme, United Utilities' cashflow per share is an ample 165.35p, while for Severn Trent, currently yielding 4.91 per cent, it is a lavish 211.97p. Clearly, utilities still enjoy flourishing revenue streams.

Many other sectors are experiencing dividend cuts, however, and a big issue for investors is whether this should be a clear sell signal. Slashing its dividend is not something any management does lightly and it almost always prompts a share-price drop, but not of cataclysmic proportions as trading performance is subject to rigorous disclosure requirements.

Yet a dividend cut remains an inordinately sensitive event. Jonathan Bloomer, Prudential's former chief executive, thought that his March announcement of a 40 per cent increase in UK business would be sufficient to save his job. But the City could not forgive the Pru's bungled rights issue, its failed bid for American General and last, but by no means least, the company's first dividend cut since the First World War.

Every analyst report, newspaper column and bulletin board that has commented on Bloomer's denouement still gripes on about that dividend cut - although it transpired way back in 2003.

Derek Pain is away

cash@independent.co.uk