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How to structure a dividend focused portfolio

December 2017


Tags: First Time Investors

Record low interest rates and increasing inflation being no good for cash savers is something most people will be familiar with hearing about, but if you’ve got cash, what should you do?

Any investors looking to secure an income from their cash in 2017 could look at dividend-yielding stocks as an option.

Dividends, the regular payouts made to shareholders by listed companies, have been particularly important to the UK stock market in the last few turbulent months. Investors with dividend-paying shares have been benefitting from the falling pound when these payments are made. That’s because many of the large dividend-paying companies receive much of their earnings in euros or dollars, and the subsequent payouts to shareholders are larger in pounds when the pound weakens against these currencies.

The most recent dividend figures show a 1.9 per cent increase in dividends in the third quarter of 2016, helped by multinationals whose dividends are denominated in dollars or euros, but then paid in sterling. According to Capita’s report, the result of the Brexit vote meant an extra £4.3bn was paid out in dividends during the second and third quarter of this year. This type of dividend growth is expected to continue into 2017. One current forecast suggests that FTSE 100 dividends will rise by £4.6 billion to £78.4 billion in 2017. This is a yield of 4.2 per cent - far more than savers can get in a savings account.

However, not all dividend-producing stocks are created equally, and investors who are keen to make the most of dividends need to be sure that they understand the risks with companies in which they are investing, and ensure that they produce a diversified portfolio of stocks to reap the benefits.  This is particularly important at present, when demand for shares with strong dividends is very high, and companies are under pressure to make cash payouts to shareholders.  

Learn why reinvesting your income can have a big impact on your investments over the long-term

Keep it covered

When creating a dividend-paying portfolio, it’s important not to just go for the companies that give you the highest payouts. It is tempting just to look at the yield - a simple percentage worked out by dividing the dividend per share by the price of per share - rather then considering the sustainability of any payments.

Companies can stop paying dividends at any time, and often do. Last year, for example, city stalwarts including Centrica (which owns British Gas), Rolls Royce, Rio Tinto and Anglo American all reduced their dividend payouts, causing pain to those who rely on regular income from their shares.

Publishing group Pearson announced a dividend cut in January, indicating that 2017 would continue the trend set by the previous year.

So where share yields look high, it is important to also consider dividend cover, another ratio that may tell you more about the company’s ability to make payouts.

Dividend cover shows how well the dividends that are paid by a business are covered by the business’s earnings. It is worked out by dividing the company’s earnings by the income paid to shareholders. If a company has dividend cover of one, for example, it is paying all of its profits out to shareholders, leaving it little room to manoeuvre or invest in building the business. Some companies have dividend cover of less than this, meaning they are paying out more than they earn. While this may be a deliberate strategy to deplete overfull coffers, it is obviously unsustainable in the long term.

If dividends don’t appear well covered, it is worth doing some digging to find out why not, and if a cut is coming. If there’s no strategy in place, it is unlikely those high yields can be relied upon for the future. FTSE 100 companies whose dividends are covered more than twice include Kingfisher, 3i, and RSA insurance.

 

Look small

Another temptation may be to amass a portfolio of the biggest dividend payers in the UK - those in the FTSE 100. But with half of FTSE 100 dividends forecast to be paid out by just seven companies next year, this may not provide the diversification that you need. Income investors could also consider smaller stocks with high dividend yields and good dividend cover - although always with the caveat that smaller stocks can find it harder to ride out economic crises.

As well as their strategies and balance sheets, it is important to consider the sectors in which these firms operate. Those with a high level of exports may benefit from a weak pound, but those importing raw materials will struggle with rising prices.

As an indication of how well small-cap companies can perform in terms of dividends, MI Chelverton’s UK equity income fund, which was the top performer over five years in the sector at the time of writing, according to Morningstar analysis, holds almost half of its assets in smaller companies. Top holdings include Lavendon Group, an equipment rental specialist in the FTSE small cap index, and housebuilder Galliford Try, from the FTSE 250.

 

Go global

When it comes to picking dividends, the UK is certainly not the only place to look. Considering investments in other parts of the globe will help to diversify your portfolio and take some of the focus away from the UK’s uncertain political position. Of course, investing in other areas of the globe - particularly unknown emerging markets – can have its drawbacks. These may include uncertainty, political risk and exposure to currency fluctuations.

If you are unsure where to start, funds that specialise in high income stocks in the areas you are interested in may help you to pick. Schroder’s Global Equity Income fund, for example, returned 35 per cent in 2016. The fund holds 43 per cent of its assets in the US, 17 per cent in the UK, 7 per cent in developed Asia and 4 per cent in emerging Asia. Top holdings include large global companies such as Intel and HSBC.

 

Get expert help

If you aren’t comfortable creating your own dividend portfolio, you can always turn to the experts to help you. There are a variety of fund managers who specialise in creating funds focused on maximising the income from shares.

You can check the total yield of the fund itself, as well as its top holdings and past performance, to consider whether it suits your needs. There are income funds that specialise in smaller companies, various overseas jurisdictions as well as those with a wider remit, to help you to balance your portfolio.

For example, Somerset Emerging Market Dividend Growth fund, managed by well-rated manager Edward Lam, saw increases of 28 per cent in 2016. Large holdings include Hungarian bank OTP, and the fund has a large proportion of financial services holdings.

Another larger emerging market income fund is Polar Capital, run by William Calvert, which delivered 30.4 per cent last year. However, it lost 14.3 per cent the previous year, illustrating the volatility of emerging market funds. The company also has a strong financial services bias, with its largest holdings in Asia, including household names Samsung and VTech.

Financial information website Morningstar allows you to rank funds within a sector by performance over one, three or five years on an annualised basis. You will also be able to look at the main holdings in any fund and see the strategy of the fund manager.

In the UK equity income category, some of the biggest funds include those run by Invesco Perpetual and Neil Woodford, a former Invesco manager who now runs his own business. The Woodford fund returned 3.3 per cent last year (based on the Z class shares offered through fund platforms). The Invesco fund, now managed by Mark Barnett, returned 2.7 per cent.

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Selftrade does not provide investment advice. This article is the authors view and is not the view or opinion of Selftrade and Selftrade accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.

The value of investments can fall as well as rise and any income from them is not guaranteed and you may get back less than you invested. Past performance is not a guide to future performance. We do not provide advice or make recommendations about investments. If you have any doubts about the suitability of an investment, you should seek advice from a suitably qualified professional adviser.

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