This could be one of the best financial moves you’ll ever make

published 24 October 2011

On Friday I made the case for investing in high yield stocks with a FTSE 350 dividend plus ETF.

With inflation running at 5.2%, the FTSE 100's payout of 3.5% is just too tight. It doesn't give you a real' return. With the FTSE 350 high-yielders, you at least have a reasonable chance of beating inflation.

But Friday's issue prompted a great question from Chris: "Is it accurate to say a yield on stocks below inflation is negative in real terms? Because all things being equal shouldn't a company grow fast enough to grow the dividend faster than inflation?"

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This is an incredibly important question. Can we rely on equities to provide long-term savings income with real' returns?

I think they probably will. It's why on Friday I said that over the long term, buying stocks now might be one of the best financial moves you'll ever make.

And I don't say that lightly!

Though I'm nervous about the short-term direction of the markets, I think there's great value out there especially in high yield stocks. Here's why.

Dividends are only half the story

There's an important concept in the financial markets. It's called the yield gap'. It compares stock yields with government bond yields. The basic idea is that investors are generally prepared to accept a lower yield from equities because they expect dividends to grow over time.

With the fixed coupons from a long government bond, you're never going to get any growth. Worse, if inflation strikes, you could end up badly bruised. The real value of your coupons could plummet.

The more growth investors expect, the bigger the yield gap. But today the FTSE 100 yields about the same as a long bond. But as Chris implies (as does the yield gap theory), surely there's an opportunity in stocks here you're getting the growth for free!

I tend to agree there's certainly value here. Because when you are buying high yield stocks right now, the dividend is only half the story. There's also all the money the business earns for us, but decides not to pay out to shareholders.

How do we take account of that?

Well rather than look at the dividend yield, what we do is look at the earnings yield'. This ratio is simply company profits (or earnings) divided by share price.

So if you buy a stock for a pound and it earns 10p per share, then its earnings yield is 10% (10/100= 10%). The fact that the stock may only pay out 3p as a dividend is neither here nor there.

Right now the FTSE 100 has an earnings yield of 11.5%. If you put £100k into the FTSE 100, then the businesses you're invested in will make about £11.5k for you. Now you won't get that sort of a return in a bank account!

But and it's a big BUT the big FTSE 100 companies only choose to pay out about a third of these earnings. That means you walk away with a mere £3.5k on your £100k investment.

Which begs the question

Where's the money going?

I can't remember the big FTSE companies ever holding back as much profit as they do today. I've always worked on the assumption that it's prudent for a business to hold back half of the earnings, while paying out half to shareholders.

That means the dividend is twice-covered. It should leave enough profit in the business for growth and it gives me a tangible return on my investment. At the same time, if the business suffers a hiccup, it means the company should still be able to pay the dividend there's an inbuilt safety net.

Right now the FTSE's dividends are more than three times covered. That means management are either being ultra-cautious, or they're saving up for some big investments or maybe a bit of both?

With the economic environment as it is, it obviously pays to be cautious. Holding back earnings to build up company balance sheets is fair enough. Even if the economy falls on hard times (as I suspect it will), there's a buffer in place.

I also like the idea of our businesses saving up a few quid to fund foreign expansion.

Every day I read about how many of our great companies are growing earnings in the emerging markets. Though much of the West is stagnating, there are still many exciting opportunities out there.

And the good news is that right now businesses can afford to pay out dividends and still re-invest for growth. I'm still plumping for the high-yielders though that's how I can assure an inflation beating return today.

Where to find the best high yielders

Right now the markets are volatile. So we shouldn't rush out and stake everything on high yield stocks! I'm personally sitting on about 25% in cash.

But I do think there is great value in high yield stocks at the momet. There is no doubt in my mind that high yield stocks will provide the better investment over government bonds in the long run.

That's why I made two recommendations last week. First, I recommended that you buy the FTSE 350 dividend plus ETF (IUKD.LN).

And secondly, I recommended that you get in contact with Stephen Bland. Over the last few years, his high income strategy has proved a very successful one for his Dividend letter subscribers.

And with the Bank of England committed to rock bottom interest rates for some time, I expect a lot more Right Siders to flock to the Dividend Letter in the year ahead.

You can find out more about Stephen Bland's great strategy here.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.