Where to fish for income as economic tides turn

It's time to switch out of big income-paying blue-chips and look for decent returns elsewhere, say John Stepek and Phil Oakley.

Almost ever since the financial crisis started, we've been suggesting that you invest at least some of your money in big, safe, income-paying, blue-chip stocks. The idea made a lot of sense.

On the one hand, central banks were hell-bent on reflating the economy again by any means necessary so having some money in stocks was a good idea. But on the other, recession and even depression loomed so you wanted to be holding companies that were virtually bullet-proof, regardless of the economic weather, and that could keep paying an income even if share prices weren't going to do much.

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These companies have performed well in fact, a portfolio of them that we put together last summer has soundly outperformed the FTSE All-Share, as Phil Oakley demonstrates below. But can the good times continue?

Perhaps we'll look back one day on the news that Neil Woodford, Britain's most high-profile equity income manager, is leaving Invesco Perpetual to strike out on his own next year, as a sign that the sector had peaked.

One of the reasons why income stocks have done so well is because record low and falling interest rates have made anything paying a steady, reliable dividend very attractive.

People who wouldn't have touched the stock market with a ten-foot bargepole have felt driven to buy blue chips as interest rates on their bank accounts have languished at below-inflation levels.

And while interest rates remained low, or even falling further, investors were happy to lock in income at ever-shrinking levels. A bond that offers a fixed 5% income today looks very attractive if you think that interest rates will drop to 2% next year.

The same goes for low-growth, high-yielding income stocks. And as rates continue to drop, investors will accept lower and lower bond and dividend yields, driving up prices.

However, rates now look as though they have hit rock-bottom. The Federal Reserve caused a stir this year by threatening to slow down the rate at which it is printing money.

The Fed held off doing that for now and it's not clear by any means when it will eventually stop printing money, let alone raise rates but as Jacob de Tusch-Lec of the Artemis Global Income fund told FT Adviser last week, the "direction of travel is clear". Interest rates will be heading higher.

This is bad news for the price of assets that are mainly in demand for the income they generate because the virtuous cycle of falling yields and rising prices goes into reverse. Bond-market investors are already tearing their hair out.As Rick Rieder, BlackRock's chief investment officer for fixed income, puts it: "Nothing in fixed income is cheap."

As the Financial Times reported last week, many bond-fund investors are now looking for ways to boost their investments in equities or more obscure areas of the bond market.

Toxic politics

The point is, the backdrop is changing. Life is going to get much tougher for pure income investments. And it's not just the economic environment that's becoming more hostile. The other reason to be wary of traditional income plays is that they are under scrutiny by cash-strapped governments looking for ways to raise money. The utilities are the most obvious example.

Energy companies are in the firing line, with the government now under pressure to find a way to match Labour leader Ed Miliband's promise to freeze prices former prime minister John Major has even called for a windfall tax.

There are undoubtedly many things that could be done to improve Britain's energy situation, but imposing price controls and random taxes on the companies you rely on to invest in and maintain these networks is not among them.

Tax hikes on energy companies will end up being passed on to consumers one way or another. But it's less politically unpopular to tax a population through its energy bills than by taking it from their pay packets directly.

There are even hints that the water utilities could be next, with one "senior government adviser" telling the Financial Times that "our focus is on improving the cost of living for bill payers and increasing competition. But there is no reason we can't do this while also making companies pay more tax."

In effect, politicians are saying that the regulators of these sectors aren't doing their jobs properly. That puts a lot of pressure on said regulators to err on the strict side when they next review how much money these companies are allowed to make.

You could argue that any cash-generative company could come under attack. But it's far easier for the government to attack an unpopular, regulated, utility-type stock that's ripping off' customers, than to impose extra taxes on the sort of growth' companies that we're meant to be relying on to get us out of this economic slump.

In short, pure income stocks have had a good run. But now that the backdrop is becoming more hostile for such stocks, it's time to consider putting your money to work elsewhere. Below, Phil has some ideas on how to do just that.

How to build a high-yield portfolio

The last few years have been kind to equity income investors. As interest rates have been screwed down by central bankers, the interest rates (or yields) on most investments have fallen too, and their prices have gone up.

As interest rates on savings accounts and bonds have been squeezed, the dividend yields of blue-chip shares have become more attractive to investors. As a result, buying these shares has paid off handsomely.

Last year we produced a special report on income investing for MoneyWeek readers. We put together a 16-stock portfolio with high-yielding shares from different sectors of the stock market. An equal amount of money was invested in each stock. This was intended to be a buy-and-hold portfolio, with dividend income re-invested back into the shares in order to compound wealth over time.

As you can see from the table below, last August it was possible to build such a portfolio with some very attractive yields. This portfolio has made a decent amount of money (with dividends reinvested) and has performed better than the stock market as a whole as measured by the FTSE All-Share index.

But can it continue? It's worth considering how the total return from shares is made up, as this can give us an insight into what we can expect from any given share in the future. The total return is simply the dividend payout you get, plus any rise in the share price. Put another way, you can say that the return you get from any share comes down to the dividend it pays, the growth rate in that dividend over time and any change in how much the market is willing to pay for that return (the stock market rating of the share, as measured by its dividend yield, or price/earnings ratio).

So, say a company pays a dividend of 5p a share, and has a share price of 100p that gives you a starting dividend yield of 5%. Its dividend is expected to grow by 10%, to 5.5p. Let's say that in a year's time, the stock market is still pricing the share at a 5% yield. That means its share price will be 110p (5.5p/110p gives you a 5% dividend yield). So the total return to the shareholder over the year will be the 5p dividend plus the 10p change in share price or 15% (15p/100p).

What stands out in the table above is that the dividend yield on many of the shares has come down substantially. Since all of the companies on the list have maintained or even grown their dividends over this period, what this tells us is that the market has been prepared to accept a lower yield, and so has pushed the price of the shares up. In other words, shares paying a half-decent income have been in demand, because it's been very hard to find income elsewhere. Shares in some companies such as Marks & Spencer, Reckitt Benckiser, Dairy Crest, and Britvic have seen very big gains indeed from this effect.

However, will investors keep driving the prices of dividend-paying stocks up and yields down? If interest rates rise, or even bottom out, as now seems likely, then probably not, as John notes above. In fact, the opposite could happen. Investors may start looking for higher dividend yields. If investors want higher dividend yields, that either means that share prices have to fall, dividends have to rise, or we have to see a combination of the two. So how do you deal with this as an investor?

Focus on dividend growth

Well, what this means is that, while focusing tightly on high yields and income has paid off recently, it may not in the near future. So what should you look at instead? Well, when interest rates rise, it's usually because the economy is showing signs of recovery. In that case, although rates might be rising, the profits of companies exposed to that recovery should rise too.

In turn, that means they should also be able to grow their dividends to offset the impact of investors demanding higher yields. This is why history shows that companies which can grow their dividends quickly over time often turn out to be far better investments than those which offer a high yield to start with, but low growth.

The downside is that you can rarely find shares that offer both a high yield and rapid dividend growth. That's because high-yielding shares tend to be in mature industries with low growth rates. They pay out most of their profits in dividends. The FTSE 100 is full of this type of company. Faster-growing companies on the other hand, retain a bigger proportion of their profits to reinvest for more growth. These shares tend to have lower yields but higher dividend growth.

So how do you find reliable companies with high dividend growth and a half-decent yield? Well, we've had a trawl through the UK market and looked for companies where dividends are covered at least twice by profits with expected dividend growth of at least 6%.

The pool is depressingly small, which may be telling us that the UK stock market as a whole does not offer particularly good value just now. Among companies of a reasonable size, which can be traded easily, we found seven BT, Petrofac, William Hill, WHSmith, Inchcape, Stagecoach and Fenner that met our criteria, as the table below shows.

There are no big yields here. However, these companies are expected to deliver strong rates of dividend growth. And their profits are expected to cover these dividends comfortably, which suggests they are sustainable and may have the scope to continue growing strongly.

How much could these stocks return over the next year? The table above provides a very rough and ready way to estimate this reality could be very different, but it's a good way to compare between stocks.

Assuming that investors expect to have the same dividend yield from these companies in a year's time (not at all guaranteed), that suggests you could get a potential return of more than 17% for BT, or more than 15% for Petrofac, if their dividends grow as expected.

How does that compare to more traditional high-yield shares? We look at some of the best-known names in the table below as you can see, the potential returns look more modest.

Companies such as Shell, National Grid, Reckitt Benckiser and Vodafone have very low rates of expected dividend growth and don't look to offer very good value at the moment.

Utilities like Centrica, SSE and Pennon on the face of it could give reasonable returns but as we mentioned above, there's a lot of political risk in that sector.

One high yielder that still stands out however, is HSBC. Banks still worry investors, as memories of the financial crisis are not easily forgotten. But HSBC, while undoubtedly riskier than other income stocks, could be a good investment. The bank is less exposed to dangerous areas such as the UK housing market and is well diversified across the world.

Some worry that an emerging market slowdown could hurt it. But it is cutting costs and is comfortably funded from customer deposits rather than riskier wholesale finance that dried up in the credit crunch. With a forecast yield of 4.6% and double-digit projected dividend growth, this could be one income stock to back.

Funds to consider

If you don't like taking the risks of picking individual stocks, but still want to invest in shares paying sustainable dividends, then a fund that specialises in them might be a good idea.

The SPDR UK Dividend Aristocrats ETF (LSE: UKDV) invests in a portfolio of 30 shares that have maintained or grown their dividends for at least ten consecutive years. The ETF pays a dividend of 3.7% and has a total expense ratio of 0.3%.

A braver choice might be the Edinburgh Investment Trust (LSE: EDIN),which has a 4.4% yield and a total expense ratio of 0.7%. The uncertainty caused by star manager Neil Woodford's decision to leave Invesco means this trust now trades at nearly a 4% discount to the value of its underlying assets.

Woodford could keep running the fund with his new venture or it may pass to his colleague Mark Barnett who also has a good track record.