Solid earners: Some firms still believe in dividends

FTSE 100 index is dominated by high-yield shares ripe for investment, says Iain Morse

Britain loves shares that pay dividends, and according to a new report from HSBC Investment Bank this is a good time to buy them. HSBC's strategist, Robert Parkes, points to the historically narrow gap between the yield on shares and bonds to argue that shares look very good value.

"There plenty of examples to support this," says Chris Harris of the private client stockbroker Charles Stanley. He picks out the oil giant, Shell, which has been under a cloud lately, forcing its chairman, Sir Philip Watts, to resign. Shell shares trade on a net dividend yield of 5.24 per cent and a forward price to earnings ratio (p/e) of just 11.37 against an average of 17.2 for other FTSE 100 companies. "This is a value play with good prospects of better than 5 per cent dividend growth, which makes it a nice earner," says Mr Harris.

The key to investing for dividend lies in company cash flows, profits, yields, dividend cover and p/e ratios. After all, dividends can only be paid from net profit. "And they are a strong though not decisive indicator that a business is robust," says Julian Kane, equity income fund manager at F&C Investments. "Cash flow is a basic sign of health in a company, and when it is distributed to shareholders it serves as a sign that the company's management are clearly focused on shareholder value rather than,say, self-aggrandisement."

While dividends are paid and expressed in cash, the dividend's yield takes that cash sum and calculates it as a percentage of the share price. A 20p dividend when a share is trading at 200p gives a 10 per cent yield.

Dividend cover is just as important and expresses the ratio of after-tax profit to dividend distributed; a company with profits of £2m paying dividends of £1m would have cover of 2, showing it can easily afford the payment. When cover comes down to one, the dividend is in danger.

P/e ratios divide a company's dividend by the price of its shares, showing how many years' profit a company would have to make to equal the share price. It is a simple but powerful tool for comparing one share price with another.

A glance at the composition of the FTSE All-Share Index in terms of these ratios throws up some interesting results. The net dividend yield for the FTSE 100 is 3.2 per cent, for the Mid Cap 250 2.6 per cent and for the Small Cap index just 2.1 per cent. P/e ratios increase as dividends fall, from 17.2 for the FTSE 100, to 20.1 for the Mid Cap and 56.0 for the Small Cap.

"This is as you would expect," says Mr Harris. "Small and mid sized companies retain more profit to finance expansion, large ones less so."

Some of the highest-yielding sectors also happen to be the largest ones in the FTSE All Share. This makes the UK market higher-yielding and more defensive than many of its international counterparts.

Take the banking sector, which accounts for about a fifth of the value of the All-Share index. While the average net dividend for the All-Share sits at 3 per cent, the Banking sector's is 4.1 per cent. The next largest sector, Oil & Gas, pays an average 3.3 per cent and accounts for just over a tenth of the index. In third place, Pharmaceuticals & Biotech, with 9.1 per cent of the index pay an average 2.7 per cent. Several smaller sectors pay more than this; Life Assurance yields 4.1 per cent, Tobacco 4.2 per cent, and Utilities 4.4 per cent.

Very high dividends can be a sign of corporate ill health. "Declining industries or companies trying to keep investors loyal sometimes pay over the odds," says David Berry, who runs several equity income funds at Martin Currie Investment Management. "You always need to look past headline figures at balance sheet strength, and not just the sustainability of current dividends but the prospects for their real growth."

Hence the importance of dividend cover on a sector-by-sector basis. The good news here is that average dividend cover has increased substantially over the last 12 months, driven by a strong increase in company earnings. Rises in dividends have lagged this rate of increase as companies have strengthened their balance sheets.

Even so, levels of cover vary by industry sector. The current average for the Banking sector is 1.70, 1.72 for Oil & Gas and 1.77 for Pharmaceuticals. But cover is higher in sectors like Mining, at 2.43 or Telecoms Services, 2.25. Utilities have the lowest average cover, 1.66.

Mr Harris says: "These ratios need to be interpreted against their industry contexts." Mining and Telecoms typically require longer-term investment cycles. Utilities tend to generate more cash. "And each sector always has its high yielders," he says. "In Banking Lloyds TSB pays a dividend of close to 8 per cent, Barclays only 3.8 per cent and you have to wonder how sustainable Lloyds dividend can be." But that question has been raised for a couple of years, and it said recently that it is maintaining the dividend for 2003.

Utilities look a good bet for those seeking dividends, save for the fact that our water companies face major regulatory change in 2005 which is likely to increase their overheads, put pressure on dividends and ultimately depress share prices. "It is a sector that should be treated with caution," says Mr Kane, "and one which might disappoint the unwary."

How to invest? A discretionary service from Charles Stanley costs £300 per annum plus commissions that start at 1.75 per cent. This might sound expensive if you are prepared to do your own investment homework, select stocks for yourself and trade though a discount problem. The only snag is that you cannot afford to simply buy and forget. Mr Harris says: "Dividends rise and fall so constant surveillance of a portfolio is advised."

But well-managed high-yield funds often have the best growth, as shares carrying high dividends may have been overlooked by investors. When the word gets around, the shares and dividend rise, giving investors a beneficial double whammy.

Over ten years unit trusts in this sector grew an average 106 per cent against a return of 79.4 per cent from the FTSE All-Index for the same period. Over the last three years, while the FTSE fell 14.3 per cent this sector is down by an average of only 2.46 per cent, with some funds showing gains of 10 per cent or more. The sector's best performer, Liontrust's First Income, grew 34.24 per cent in that period.