The highest-yielding stocks in four strong sectors

Oil majors aren't today's only high-yielding stocks winners in three other sectorsare also paying out well.

Dividends matter you probably don't need us to remind you that reinvesting your dividends provides by far the lion's share of stockmarket returns over the very long run. As the latest Credit Suisse Yearbook points out, if you'd stuck £100 in the stockmarket in 1900 and relied on capital gains alone, it would now be worth £240 (after inflation).With dividends reinvested, it would have grown to a staggering £44,500 (again, after inflation).

So we like dividends and we know you like them too. And right now, several big blue-chip shares are yielding well above the FTSE 100 average of around 4.5%. But are they likely to pay out? Below we look at four sectors with the highest-yielding stocks in the market today, and give our view on the best bets.

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The oil majors: BP (BP) versus Royal Dutch Shell (RDSB)

The oil majors are among the highest-yielding stocks in the FTSE 100 right now. BP is on a gross yield of more than 8%, while Royal Dutch Shell is on more than 7%. Little wonder. The price of the main product they sell has collapsed to levels that were unimaginable a little over a year ago, and both companies' share prices and profits have followed suit. Yet both firms remain firmly committed to maintaining their payout, and reiterated their plans to do so at their latest results. So which is the best bet?

Let's be clear here. As the tempting-looking yields clearly demonstrate, neither BP nor Shell are "safe" bets as far as dividend payouts go. If they were, the yields wouldn't be this high. That said, few companies save perhaps in the utilities sector can be under more pressure from large shareholders to maintain their dividends than these two. Shell alone accounts for more than 10% of the dividends paid out by the FTSE 100, and it hasn't cut its dividend since 1945, which makes the payout vital to the typical equity income fund manager if he wants to keep his investors happy.

Analysts at JP Morgan Cazenove (JPM) reckon that cutting dividends would be a good idea "to facilitate less pro-cyclical behaviour", but also acknowledge that the management teams in question "will push back and try to sustain current dividends for as long as they can".

JPM reckons that despite the resistance, BP will cut its dividend later this year, to 28 cents for 2017. That would still put the stock on a prospective yield of 5.5%. It expects Shell to cut in 2017 to $1.20 ("we believe that Shell will wait longer than BP") again, putting the stock on a prospective yield of around 5% (at current exchange rates both stocks pay out in dollars).

However, this largely depends on the oil price if it recovers, the chances of a cut recede, as profitability improves, and it also becomes easier to off-load assets that are up for sale at good prices. Shell in particular will be loath to cut. As oil industry analyst Malcolm Graham-Wood told Interactive Investor late last year: "if Shell cuts its dividend we'd be more worried about what else was going on in the market In almost any circumstance I would expect Shell to maintain the dividend at these levels".

If oil continues to recover, shareholders in either stock will be laughing. But on balance, we'd opt for Shell. As John Ficenec puts it in The Daily Telegraph's Questor section: "Shell has the strongest balance sheet in the sector, with gearing of 14%, which gives it the flexibility and time needed to turn things around".

Meanwhile, while it probably paid more for its recent purchase of BG Group than it needed to, given the subsequent depths plumbed by oil prices, the expanded group "has stronger growth potential, will benefit from further cost reduction, is more resilient in a lower-price environment, and can maintain the dividend", as oil investment bank Tudor, Pickering, Holt & Co told Bloomberg. In short, if oil prices fall further, Shell is likely to endure the pain better, while if prices rebound, it's better positioned to take advantage.

The banks: HSBC (HSBA) versus Lloyds (LLOY)

Here's an investment dilemma, writes Jonathan Compton. Arrogant Bank enjoys a powerful position across high-growth economies and reports increased profits and a higher dividend, in line with the policy of "ever upwards". Bozo Bank has struggled for seven years, with business shrinking, yet raises its dividend even though this is not covered by falling profits. Which is the better buy? The answer is Bozo or Lloyds while Arrogant Bank HSBC is doomed to a prolonged downturn and inevitable dividend cuts. The essential difference is the culture of their management.

HSBC's greatest triumph, the bargain purchase of Midland Bank in 1992, sowed the seeds of its demise. This changed "The Bank", as HSBC staff call it, from an Asian powerhouse enjoying an oligopoly in Hong Kong, South East Asia and the Middle East, to a near-global bank. The success of Midland resulted in a flurry of takeovers in Europe and Latin America, reinforcing the board's view that only they and one other historical figure could walk on water. The end game was the purchase of Household Finance in the US for $15bn in 2002. In its own hubristic words, HSBC became "The World's Local Bank". This empire is set to unravel, painfully.

Lloyds' global ambitions, on the other hand, floundered in Latin America's financial meltdown in the late 1970s. From 1984-1987, under the leadership of the hugely respected Sir Brian Pitman, it expanded inside the UK through acquisitions of varying quality, from TSB to Abbey Life and Scottish Widows. Come the global financial crisis, Lloyds could have emerged as a major winner but its chairman, Sir Victor Blank, and CEO Eric Daniels could not resist the "opportunity" offered by the beleaguered Gordon Brown in 2008 to take over the already bankrupt HBOS for £12bn. Shortly thereafter Lloyds itself had to be rescued by the government.

Although both Lloyds and HSBC lost more than twice the cost of their suicidal mega-deals, their reactions have been sharply different. Lloyds, under another highly competent CEO, Antnio Horta Osrio, has bitten the bullet and set about shrinking back to its core business, cleaning up malpractices, controlling costs and working with the regulators (resulting in £20bn of fines and provisions). Essentially it is now "clean". The underlying results for 2015 show this, hence profits and dividends should now rise steadily.

My guess is that the dividend will reach 3p next year and 3.5p in 2018. I know forecasts tend to be higher than this, but I suspect the board will want to phase out specials because, if paid too often, they become expected. The market will be happy with this, as anything over a recurrent 4% yield is a winner.

HSBC, however, continued to game-play the regulators and over-reward the board for failure, while not recognising that a 260,000 employee global model is unworkable and that horrific loan losses from Asia and the Middle East (currently over 60% of operating profits) are about to torpedo its profits. Fines are likely to remain high (hinted at in pages 445-454 of its monster annual report). Shrinkage has been piecemeal. No reform is possible until the error-tainted chairman and CEO (who made a disastrous appearance before a House of Commons committee last year) are defenestrated. The 2015 results show a business that is crumbling. In my view, the 8% dividend yield is an unsustainable chimera.

The miners: Rio Tinto (RIO) versus BHP Billiton (BLT)

Mining shares have issued a stark warning to income hunters in the last 12 months: if a dividend yield looks too good to be true, it almost certainly is, writes Alex Williams. Industry leaders BHP Billiton and Rio Tinto boasted yields of more than 8% a piece at the end of 2015, but in the first few months of this year both dividends have been cut (Rio has changed dividend policy rather than slashing the current payout, but it amounts to a cut, as we'll see in a moment). For investors in Anglo American and Glencore, the news has been bleaker still. The two groups have been forced to scrap their dividends entirely.

Will the outlook improve? Unsurprisingly, everything depends on commodity prices and, in turn, demand from China. News has turned positive in recent weeks. China's copper imports leapt 50% in February and are close to record levels, while "predictions of a hard landing are destined to come to nothing", Xu Shaoshi, China's most senior economic planner, assured markets this week.

The bullish sentiment is filtering through. The price of iron ore, the staple ingredient in earnings for both Rio Tinto and BHP, jumped by a record 19% on Monday. Glencore, which is more heavily exposed to copper and coal, has likewise said it is "very positive" on China and may reintroduce its dividend in 2017. But for investors dependent on income, all that is far too vague.

What real income has been left on the table? Not much. For the current year, Rio has pledged to hold its payout flat at $1.10 per share, equal to an unspectacular gross yield of 3% to 4%. But in future years it will be pegged at 40% to 60% of earnings, meaning dividends could fall further still, if earnings do not improve. BHP, meanwhile, has taken far more drastic action, slashing its dividend by 74% with immediate effect. However, the upshot for both groups is the same. They have walked away from their previous commitment to maintain or increase their dividends each year, known as a "progressive dividend" policy.

In many ways, that makes a lot of sense. It relieves BHP of its dividend burden, which totalled $6.5bn last year, allowing it to meander instead up and down with commodity prices. Progressive dividend policies are not suitable for mining companies, according to Panmure Gordon analyst Kieron Hodgson. "In a cyclical industry such as commodities, there are going to be boom years, there are going to be bust years," he says. Investors are buying exposure to commodities, "they don't want exposure to the balance-sheet risk that comes with progressive dividends". Equally, that means the mining majors don't suffer the weight of shareholder expectation that keeps the oil majors clinging to their dividend payouts even when it might be wise to cut back.

For Rio Tinto, the move will also boost its cash balance, giving it the flexibility to pick off acquisitions at the bottom of the cycle. Indeed, this "apex predator" status is one reason why we tipped the stock at the back-end of last year, since when it has rallied considerably, and we would continue to hold and be buyers of Rio for this reason.

However, these companies' cuts do take the big fat yield out of mining stocks at the bottom of the market. With the mining industry locked in a mentality of cost-cuts and survival, dividend cuts have become permissible, but it is worth remembering that Rio's chief executive, Sam Walsh, vowed to increase the group's dividend for the next five years less than 18 months ago. Dividends in the mining industry aren't to be trusted.

Big pharma: GlaxoSmithKline (GSK) versus AstraZeneca (AZN)

Pharmaceutical firms such as GlaxoSmithKline and AstraZeneca operate in a different type of industry to many others in this article, writes Cris Sholto Heaton. Profits don't vary much according to emerging-market demand or the state of the financial cycle: people need health care whatever happens in the wider economy. So short-term, there's little reason to worry. But pharma firms are facing longer-term threats.

First, patent expiry on major drugs: this means the drugs can be manufactured and sold more cheaply by other firms, eating into the original manufacturer's market share. Glaxo faces competition on asthma drug Advair/Seretide, which accounts for almost a fifth of its sales, while Astra is losing protection on both cholesterol drug Crestor/Rosuvastatin and acid-reflux treatment Nexium/Esomeprazole, which make up a third of revenues.

Second, returns from research and development have been disappointing for some time, meaning the pipeline of new products coming through to replace these big sellers is narrower than firms would like. Third, while an ageing population should be good for demand, it will push up overall healthcare spending, and governments may pressurise firms to cut drug prices or encourage the use of cheaper alternatives. So while both Astra and Glaxo remain extremely profitable and generate plenty of cash, there is some concern over whether their dividends are sustainable over the medium term.

Worries are most acute about Glaxo, which already carries a relatively high debt load (debt-to-equity stands at 120%) and where free cash flow (cash flow after deducting investments) did not cover the dividend in three of the last four years. On the plus side, Glaxo has been restructuring its business to focus on areas such as vaccines and consumer healthcare, where it believes growth will be respectable and pricing pressures lower. Earnings, which have been falling in recent years, should start to grow again later this decade.

In the meantime, Glaxo says it is committed to maintaining the current dividend until 2017, which should be sustainable bar major shocks but there is one complication. Glaxo's consumer healthcare business is a joint venture with Novartis, which owns 36% of the division, while Pfizer and Shionogi also collectively own 22% of its HIV drugs unit. These firms have options to force Glaxo to buy out their stakes starting in 2017. These growth businesses are a core part of Glaxo's strategy, so it would probably be better in the long run if that happened but it won't come cheap. So there is a possibility that the dividend might ultimately have to be cut to help fund those deals.

Astra is in a rather different position. There's less obvious concern about its dividend, which has been more thoroughly covered by free cash flow, and it has much less debt than Glaxo. But while Glaxo is aiming to move away from needing to find new high-priced blockbuster drugs towards a broad portfolio of lower-priced products, Astra is still following the established pharma model, investing heavily in major treatments for cancer, diabetes and heart problems.

If this pipeline generates enough big hits, Astra's earnings are likely to grow faster than Glaxo's but if not, earnings and dividends could come under threat in the future. I don't think either Astra or Glaxo are at immediate risk of a dividend cut. But on a longer view, Glaxo appears less risky even if the dividend is eventually cut, it should be to fund full ownership of two growing, relatively conservative divisions. If Astra has to cut, it's more likely to be because its strategy has not delivered than because it has better uses for the cash (Cris holds shares in GlaxoSmithKline).

How to build your own dividend portfolio

If you're an income-focused investor, then you should investigate Stephen Bland's Dividend Letter strategy. Bland's approach is to build a portfolio of higher-yielding, large-cap shares, from a diverse range of sectors "at least 15 but usually no more than 20 sectors", he says. This diversification process helps to shield against dividend disappointments (although, of course, they still happen). But what's perhaps unusual is that Bland's ideal holding period "is forever", with the dividend income either withdrawn as needed, or reinvested in the portfolio if not.

The approach sounds simple, and it is. But that's arguably one of its biggest strengths. It is a relatively low maintenance strategy, and one that explicitly avoids the need to spend a lot of time paying attention to the daily ups and downs of the stockmarket. That's generally a healthy approach for mostinvestors as countless studies have shown, investors tend tobe their own worst enemy. There is nothing wrong with takingan interest in the financial news, but the less time you spendfretting over the health of your portfolio on a day-to-day basis,the fewer impulsive mistakes you'll end up making, and thewealthier you'll be in the long run.

On top of that, the strategy is naturally contrarian. Stocksthat have a higher-than-average dividend yield are almost by definition relatively unpopular. As a result, when you buyyou're always tending to go against the grain, which makes itharder to get caught up in investment manias.It's a long-term strategy, of course. But if you're looking to buildan income portfolio, this is a useful approach. You can find outmore about The Dividend Letter here.

Tapping income in investment trusts

Another option for income-hungry investors who would rather investin a ready-made diversified portfolio is to opt for an investment trust. High yields are one thing, but consistency of dividend increases is alsoextremely valuable a trust might only offer a below-average yield whenyou first purchase it, but if the payout continues to grow, then over theyears you can build a healthy income stream from that initial investment.

The Association of Investment Companies has compiled a list of truststhat have raised their dividends for at least 20 consecutive years someof the longest-payers are listed below, including one of our favourites,Caledonia. Do remember that some trusts maintain or raise dividendpayouts by paying out money from retained income during fallow years(known as "dividend smoothing"). That's not necessarily a problem, butthe risk, of course, is that there comes a point where there are no longerany reserves to draw on.