Follow the dividend yield when buying shares

No valuation measure can help you to time the market. But dividend yields are a good guide to future returns.

Shell petrol station © ADRIAN DENNIS/AFP/Getty Images

With more than $16trn-worth of bonds sporting negative yields and the US stockmarket trading at valuations not seen except at the peak of the tech bubble, it's easy to assume that "everything is expensive". And yet, that's not strictly true. The gap between US stocks and the rest of the world is striking. American equities have massively outperformed both their developed world peers and emerging markets during the post-2009 equity rally. As a result, as Michael Mackenzie points out in the Financial Times, "a comparison of US and global equities through their dividend yields and price-to-earnings ratios bolsters the case for a reversal over the coming years that favours emerging markets and other developed world equities".

The first question most of us will ask in response to that, of course, is: when will the turnaround happen? Yet that's a mistake. No one can time the market, but we can get a decent idea of what our long-term returns might be. As The Economist's Buttonwood column points out, "Discount Rates", a 2011 paper by John Cochrane of Chicago Booth School of Business noted that income yields (whether on bonds or on equities) are a good guide to future returns. "High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns." That's because asset prices are driven more by risk appetite than by investors' earnings expectations. In other words, investors don't buy expensive stocks because they think their earnings will rocket they buy because they feel more comfortable investing in popular stocks than in hated ones.

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So where are dividend yields unusually high right now? Look no further than the UK, where the dividend yield on the FTSE 100 is standing at around 4.1%, which is well above the 30-year average of 3.5%. Obviously, there's no guarantee that just because it's cheap the UK market is likely to turn around soon as Buttonwood notes, "the signal from yield is too weak to be relied upon to catch turning points profitably". But in the meantime, you're getting paid to wait.

The Temple Bar Investment Trust (LSE: TMPL) has increased its dividend every year for the last 35 years. It now offers a yield of around 4.2% and trades on a discount to net asset value (NAV the value of the underlying portfolio) of 5%. The top holding is currently pharma giant GlaxoSmithKline, with oil majors BP and Shell also ranking highly. Another option is Shires Income (LSE: SHRS), with a yield of 5.1% and a discount of 1%. Alternatively you could go for a simple passive fund that tracks the underlying market, such as the HSBC FTSE All Share Index fund, which charges less than 0.1% a year.

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I wish I knew what an IPO was, but I'm too embarrassed to ask

An initial public offering (IPO) represents the first time that a company sells shares in itself to institutional investors (such as pension funds) and often also to individuals (retail investors). This process is also known as "floating" or "going public".

Companies go public for a wide range of reasons. They may want to raise funds for expansion, and choose to do so by selling part of the company rather than borrowing the money. Alternatively, the current owners perhaps the original founders, or a private-equity fund may wish to "exit" (ie, cash in on their investment).

An IPO is underwritten by one or more investment banks, which typically earn large fees from the process. A prospectus with details of the company

and the offering is issued to potential buyers. The IPO price is typically based on expected demand from investors. If demand outstrips the number of shares on offers (the IPO is "oversubscribed"), then the underwriter will have to decide how to allocate the shares.

If there aren't enough buyers, then the underwriter agrees to purchase the surplus (hence the term "underwriter").

A newly listed company's share price will often enjoy a "bump" on the first day of trading. However, unless you are allocated shares before the company starts trading which is unlikely with a "hot" stock then you are unlikely to benefit from this initial jump in price.

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Many studies suggest that IPOs underperform over the long run. But some are more attractive to private investors than others. Privatisations, for example, can represent good opportunities, because the seller is the government, and the last thing the government wants is for potential voters to buy into the much-hyped sale of a public utility, only to find that their investment collapses within a few months of the IPO. That said, while Royal Mail's shares near-doubled with a few months of their 2013 IPO, they have since struggled badly.

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