Equities shine as interest rates stay low

For investors seeking an income, the stock market recovery offers opportunities, says Rob Griffin

With UK interest rates at historic lows and with lacklustre yields from both government and corporate bonds, it's little wonder investors are being drawn towards equities.

The stock-market recovery and strong results from a string of household names have increased the appeal of equity income investing, in which you buy shares in companies that pay dividends or put your faith in an income-seeking fund and let its manager make the decisions.

Three types of people find this sector particularly attractive, according to Patrick Connolly, head of communications at AWD Chase de Vere: those in need of an income now; those expecting to want one in the future; and those looking to reinvest dividends for better longer-term results.

"Dividends make up a sizeable proportion of total stock-market returns, and that is why many growth investors are keen to invest in shares which produce dividends as these are subsequently reinvested to boost total returns," he explains.

However, dividends are not guaranteed. Companies can reduce the amounts they pay back to shareholders – or even cut the dividend completely in tough times.

the outlook for dividends

According to the UK Dividend Monitor compiled by Capita Registrars, the prospects for dividends are pretty good. UK dividends totalled £15bn during the first quarter of this year – 10.3 per cent up on the same period in 2010 and comfortably the highest first-quarter total since its analysis began in 2007. It expects total dividends for the whole of 2011 to come in at £64.2bn, which equates to growth of 7.9 per cent.

so how should you invest?

There are two ways to invest for income: via shares or via investment funds. Justin Modray, founder of the website Candid Money, says: "Buying companies is cheaper because you don't have to pay a fund manager, but it can leave you more exposed as funds will invest in many more stocks," he says. "Good fund managers should also be able to add more value to outweigh the fees charged."

buying shares

It can be very tempting to buy companies that have the highest dividend yield – best defined as the dividend being paid by a company expressed as a percentage of its share price – especially as a number of companies are now yielding more than 5 per cent. However, this may not be sustainable. Nick Raynor, investment adviser at The Share Centre, says: "Investors need to ensure the dividend is well covered and that the monies to pay this dividend should come from profit. They must also decide if the yield [being offered] is realistic by taking a look at past performance to see if it seems viable."

Companies perceived to be most likely to continue paying dividends are those that are able to generate free cash flow – that is effectively the amount of money they have at their disposal after paying all the various costs associated with its business activities.

investing in funds

Geoff Penrice, an independent financial adviser with Honister Partners, recommends that investors consider both qualitative and quantitative measures when choosing between funds, pointing out that he prefers those that are capable of delivering consistent returns at lower levels of risk.

"Qualitative measures include the methods and processes which the fund manager employs to research and analyse the market in which they operate, whereas quantitative is looking at the performance and volatility of the fund over different timescales and in different conditions," he says.

He cites the Invesco Perpetual Income fund, which is run by Neil Woodford, as an example of the type of well-managed portfolios with good risk-adjusted returns in which he likes to invest his clients' money.

A glance at the returns generated by funds in the IMA UK Equity Income sector illustrates the importance of choosing carefully. Over the past five years, the best funds have delivered around 60 per cent, while the worst have lost almost 20 per cent, according to Morningstar, to 21 July this year.

When selecting equity income funds be aware that many funds end up investing in the same companies. Someone with a portfolio of equity income funds may be taking on extra risk through duplicating their exposure to certain names. Five companies accounted for just over half – £7.6bn – in dividends paid during the first three months of 2011. AstraZeneca took the top spot, followed by Vodafone, Royal Dutch Shell, International Power and HSBC.

"Investors should look at the growing number of international equity income funds to hold alongside UK funds," Patrick Connolly says. "This is a sensible way to maintain a competitive level of income while diversifying risks."

We asked Patrick Connolly, head of communications at AWD Chase de Vere to pick three funds that would appeal to income-seeking investors.

Newton Global Higher Income

An international fund investing in the US, Europe, Asia and emerging markets, as well as the UK, and so providing good diversification. Newton's investment approach provide a safe pair of hands .

Schroder Income Maximiser

Holds virtually the same underlying shares as the Schroder Income fund, but gives up some of the growth to generate higher income. It targets an income of 7 per cent each year.

Neptune Income

A traditional equity income fund which invests in 33 equally weighted shares. It focuses on total return rather than maximising income and has a consistent record.

We asked Nick Raynor, investment adviser at The Share Centre, to highlight some stocks he thinks could be suitable for income-seeking investors.

Aviva

The insurance group has been expanding in European markets. Margins have also been improving as the focus has been on higher-value products. UK insurance sales in the UK rose 20 per cent to more than £1bn.

Vodafone

The mobile giant's last set of results saw the company beat market expectations, and its 26.4 per cent increase in data sales shows the rise in demand for smartphones.

Marston's

Food sales have provided a vital boost. This is a higher-risk recovery stock, with an attractive yield.