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
Shell is just one high-yielding FTSE 100 stock

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.

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.

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.

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.

Recommended

Don’t panic about Iran – but don’t sell your gold either
Gold

Don’t panic about Iran – but don’t sell your gold either

Markets have reacted calmly to the tension between the US and Iran. But don’t get too complacent. It’s still a good idea to hold on to some gold as in…
9 Jan 2020
Here’s how gold could rise above $7,000 an ounce
Commodities

Here’s how gold could rise above $7,000 an ounce

That the gold price could hit $7,000 an ounce is a logical and plausible possibility, says Charlie Morris. Here, he explains how it could get there.
30 Dec 2019
Gold is in a bull market – and it could have much further to go
Commodities

Gold is in a bull market – and it could have much further to go

Many investors forget that gold is still the best-performing asset of this century, says Charlie Morris. It could also have much further to go.
27 Dec 2019
All the gold in China: money and power goes east
Economy

All the gold in China: money and power goes east

China has far more gold than official figures suggest – as much as America, in fact. He who owns the gold makes the rules, says Dominic Frisby.
15 Nov 2019

Most Popular

The rising dollar is proving bad news for most other assets – will it last?
Investment strategy

The rising dollar is proving bad news for most other assets – will it last?

Precious metals, stocks and pretty much every other asset has taken a tumble as the US dollar strengthens. Dominic Frisby looks at how long this trend…
23 Sep 2020
Oil producers are back at their Covid-19 lows – is it time to buy?
Oil

Oil producers are back at their Covid-19 lows – is it time to buy?

With demand for oil hammered by Covid-19 and talk of “peak oil demand”, there are lots of good reasons to be bearish on oil producers. So, asks John S…
22 Sep 2020
Why you should stuff your end-of-pandemic portfolio with Chinese stocks
China stockmarkets

Why you should stuff your end-of-pandemic portfolio with Chinese stocks

For an end-of-pandemic portfolio, you need assets that can cope with today’s volatility. And that, says Merryn Somerset Webb, means Chinese stocks.
14 Sep 2020