How to get reliable income from stocks

In these sideways markets, gaining income from your portfolio is key. But before you buy your next high-yield stock, make sure it passes these four tests, says Tim Bennett.

Following the rampant bull market of the 1980s and 1990s, we now seem to be stuck in a sideways' market. Most major indices have yet to regain the tech-boom highs of 2000, and they have fluctuated wildly in between, hitting significant lows in both 2003 and 2009. So how do you make money in this sort of market?

There's one simple answer: income. If you can't rely on big gains from capital growth, you had better make sure your investment is paying you a decent yield. "Dividends are a critical driver of equity returns over time but especially when markets are range-bound or falling," as Graham Secker at Morgan Stanley's Global Equity Strategy Team puts it in a recent research paper.

How do you find stocks that will pay you a reliable income? Secker suggests there are four tests that a dividend-yielder needs to pass to be worth adding to your portfolio.

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A high and rising dividend yield

Morgan Stanley starts the search with firms that show a consistent dividend trend across three periods: 2011 (where the yield is known); 2012 (where the interim dividend is known but the final is forecast); to 2013 (where the total dividend is forecast). In particular, it wants to see a dividend yield of 3.5% or higher and a rising trend over 2012 and 2013, since future dividends obviously matter more to an investor than past ones.

Forecasts are notoriously untrustworthy. Dividends can, after all, be cut at any time. But with fear widespread right now, directors know that cutting the dividend can result in a share-price battering. They'll avoid it if they can. If they have the confidence to raise it, that's a good sign. Thus a high, rising yield is a good starting point.

A sustainable payout ratio

The payout ratio is simply the amount the directors choose to pay out as dividends, as a proportion of the total profits available. If a firm generates annual profits of £100m and pays a dividend of £60m, the payout ratio is 60%. There are two ways to view this ratio.

On the one hand, an income-seeker needs to find firms with decent payout ratios there's little point in expecting a firm that pays out 5% of its profits, even if those profits are sizeable, to generate the income you want. However, you also don't want to rely on a firm that has little room for manoeuvre because its payout ratio is already high.

For example, a firm might be a generous dividend payer, but if its payout ratio is, say, 90%, the board will have almost no choice but to cut the dividend if profits dip even slightly. So what is "sustainable" in the current climate? Morgan Stanley looks for stocks where the average 2012 and 2013 payout is less than 75% of available profits.

Go for large stocks with low debt

Next you should carry out a size and balance-sheet check. While it's perfectly possible for the lumbering giants of the corporate world to go bust, Morgan Stanley believes that the risks associated with large caps are lower than small caps when it comes to dividends. Big firms often have longer track records and the cash resources to weather short-term turbulence. To qualify for selection, a firm must have a market capitalisation of at least $3bn. It must also carry a low level of financial risk, so balance sheet gearing (the ratio between debt and the firm's market capitalisation) must be below 30%.

Gearing is a pretty rough and ready test of financial strength: a firm carrying even low levels of debt can still go bust if it can't meet its interest payments out of profits. But one thing's for sure an investor buying into a firm with high gearing is likely to find the dividend being crowded out by interest on debt (which, legally, has to be met first). By picking 30%, Morgan Stanley is building in a decent safety margin.

A solid free cash-flow yield

This measures the ability of the firm to generate cash for shareholders. Without cash there can be no dividend payment. The calculation is similar to the dividend yield except this time it takes the firm's annual free cash flow (the cash left over from operating activities once certain commitments, such as the tax bill, have been met) as a percentage of the share price.

Morgan Stanley sets the bar at 5%. Three stocks that pass the four tests and that look promising options to us include pharmaceutical giant AstraZeneca (LSE: AZN) on a 2012 yield of 6.9%; oil giant Royal Dutch Shell (LSE: RDSA) on a 2012 yield of 6.6%; and defence firm BAE Systems (LSE: BA) on a 2012 yield of 5.2%.

Invest like the experts

Ever wished you could pick the brains of the world's greatest investors? Stockopedia has put together a stock-screening tool that lets you do just that.

Built on Thomson Reuters data, it allows you to build a portfolio of listed UK stocks chosen based on the ratios favoured by the likes of Berkshire Hathaway's Warren Buffett or Gotham Capital's Joel Greenblatt.

You can also alter the screen to incorporate your own preferred metrics, or build your own from scratch, all within the same package. There's also plenty of background material on each of the screens and gurus covered. Is it worth considering?

It's certainly a powerful system. However, you do have to pay for it a subscription will cost you £14.99 a month, or £149 a year. That means it's only really suitable for investors with decent-sized portfolios in effect, you're adding a 1.5% annual charge on a £10,000 portfolio.

Also, the back testing of the various strategies on offer only goes back as far as the start of this year, so it will help if you already have a good idea of what sort of strategy you're looking to follow.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.