Common sense view on dividends is wrong

According to research by American academics, the commonly held assumption that low dividend payouts are a sign of future earnings growth is wrong. Using this philosophy, here are the best tips for potential investment targets on the London market.

"History provides little support for the commonly held assumption that low dividend payouts are a sign of future earnings growth to come," says Timon Day in Shares. In fact, according to research by American academics Robert Arnott and Cliff Asness, just the opposite is true. They analysed 50 years of data from US firms and showed that "future earnings growth is fastest when the current dividend payout ratio is high and slowest when pay-out ratios are low". This corroborates Michael Jones' and Steven Greiner's view in their research paper Stock Selection: Do Dividends Matter?, which concluded that "dividend-paying stocks with yields between 1% and 4% consistently outperformed non-dividend-paying stocks".

Of course, there are exceptions, such as Berkshire Hathaway and Microsoft, but they only serve to "prove the rule". According to Jones and Greiner, the "sweet spot" in order to maximise returns consists of a portfolio of stocks with yields between 3% and 4%.

Using this philosophy, Shares suggests a dozen potential investment targets on the London market with decent yields and a high rate of dividend growth. One of Lloyd's largest non-life insurers, Amlin (AML, 282p), will benefit from "big premium increases" following a year of disasters. Assuming there is no repetition of such disasters, the company's dividend is forecast to rise around 28% to yield 4% in 2007. In the meantime, according to Yahoo, it is trading on a prospective p/e of just 7.8 times next year's earnings.

The other 11 were: Aquarius Platinum (AQP, 807p); Telford Homes (Aim:TEF, 210p); Terrace Hill (Aim:THG, 57p); Mouchel Parkman (MCHL, 347p); Detica (DCA, £12.90); Kensington (KGN, £11.32); Majestic Wine (MJW, 316p); Zytronic (Aim:ZYT, 270p); Severfield-Rowan (SFR, £12.58); Go-Ahead (GOG, £18.74) and "ten bagger" Mears (Aim:MER, 316p).

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