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Exploring the different types of dividend shares

Despite what you might hear from the financial media who have been quick to talk about dividend-paying shares as if they were a separate asset class, dividend-paying shares are not a monolith. They don’t trade in lockstep with each other any more than do two shares that use buybacks instead of dividends, or a gilt and non-investment grade bond.

Indeed, a share that trades with a 2% dividend yield probably has very little in common with a share that yields 6%. All else being equal, the two companies are likely at different stages in their growth cycles, have different risk profiles, and different dividend policies.

The simplest way to start classifying dividend-paying shares is to find the market average yield (we’ll use the FTSE All-Share), which is currently 3.5%, and call everything above the average ‘high yield’ and everything under it ‘low yield’.

Yet even that classification can be misleading, though, as there are extremes on both sides to consider, as well.

Four types of dividend shares

I reckon we can use four yield categories to establish a reasonably accurate matrix for understanding the spectrum of dividend-paying shares.

Yield category Dividend yield range Translation
Afterthoughts <2% Likely a company in a growth phase; yields are so low that dividends are likely not a part of your main investing thesis.
Dividend growth 2% to 1.2x market average Likely a company in the mature growth phase; expectation that the share will provide a higher income in 5-10 years.
High yield 1.2-2x market average Likely a company growing near the GDP rate; your expectation is to harvest high levels of current income.
Stratospheric >2x Market Average Likely a company in decline or in financial trouble; higher risk of dividend cuts.

Yield ranges as of 10/10/2012.

These are generalisations, of course, and there are always exceptions, but it’s still helpful to see that dividend yields can usually tell us quite a lot about a share.

Perhaps most importantly, it helps set expectations. You shouldn’t buy a share in the high-yield category, for example, expecting 15% annualised dividend growth. It’s simply not likely.

Avoid the extremes

We can set aside ‘afterthoughts’ for our discussion here. Investors primarily interested in dividend-paying shares for income won’t likely waste their time with such low yields.

To see why, consider the following chart tracking income in three scenarios over a decade:

  • 1% yield growing at 15% annualised
  • 3% yield growing at 9% annualised
  • 5% yield growing at 4% annualised

As you can see, even after a decade of 15% annualised growth – a very high growth rate – the share yielding 1% today will still produce far less than the annual income of the other two yield scenarios. Consequently, the low-yielding ‘afterthoughts’ are just not of interest to dividend-minded investors.

We can also set aside stratospheric yielding shares for now. These are shares yielding more than 8% in today’s market – or roughly twice the average. Such ultra-high yields are a special case unto themselves, and they require a distinct analysis. The alluring high levels of current income the stratospheric yielders appear to offer is likely to be unsustainable in the medium-term, and as such investors should approach them with the utmost caution and not purchase them for yield alone.

Having eliminated the two extremes, we can focus on the sweet spot of the dividend yield spectrum – the ‘dividend growth’ and ‘high yield’ categories.

I believe an investor looking to build a portfolio that generates a sustainable and growing stream of income is best served by focusing on these two categories. You should find plenty of selection here without taking undue risk.

Dividend growth shares

What we’ll generally find with dividend growth shares – which in today’s environment are shares yielding between 2% and 4% – are companies that have passed their high-growth stages but continue to retain a significant percentage of their earnings to reinvest in the businesses.

In this space, dividend cover ratios are usually at least 1.8-2 times.

A few classic dividend growth examples today might include Domino Printing Sciences (DNO), London Stock Exchange (LSE), and Diageo (DGE).

The trick with dividend growth shares is, well, the growth part!

Since you’re forgoing a little jam today in hope of more jam tomorrow, you want to feel confident that there will in fact be more jam in a few years’ time. After all, a share yielding 3% and growing its annual payout below the rate of inflation won’t do an income-seeker much good.

Ideally, you want dividend growth shares to offer at least three percentage points above inflation. With RPI inflation coming in at 2.9% in August, for example, that means you’ll want to target at least 6% annualised dividend growth from shares in this category.

In future posts, we’ll discuss more tools for analysing dividend shares, but one way to get a better idea of a share’s dividend growth potential is to determine the company’s sustainable growth rate (SGR).

To arrive at the SGR, take the five-year average return on equity and multiply it by the most recent retention ratio (1 – dividend payout ratio).

What the SGR is telling you is the maximum rate the company can grow without changing its financial leverage (increasing/decreasing debt, etc.)

For example, if the company’s average return on equity has been 15% and it is retaining 50% of its earnings, the sustainable growth rate is 7.5%.

If you’re researching a share in this category, one of the things you want to ensure is that SGR is above your annualised dividend growth threshold. Certainly there are other factors to consider before making a buying decision, but SGR is an important one.

High yield shares

Investors who prefer their jam today will likely focus on the high-yield area of the market, which as I write ranges from around 4% to 7%.

For a real-life example of such a portfolio, check out The Investor’s demo HYP here on Monevator.

Companies that fall into the high yield category have likely passed their above-average growth days and have now settled into growing more or less at the rate of the broader economy.

Classic high-yield mainstays in today’s market include SSE (SSE), Vodafone (VOD), and AstraZeneca (AZN).

When analysing high yield shares, it’s critical to keep a few things in mind. First and foremost, your focus shouldn’t be so much on growth potential, but sustainability of the dividend. As such, more emphasis should be placed on the strength of balance sheet and free cash flow cover.

To gauge balance sheet strength, I recommend considering the quick ratio ((current assets-inventory)/current liabilities) for short-term liquidity analysis and the interest coverage ratio (EBIT/interest expense) and debt-to-EBITDA ratios for longer-term credit analysis.

A company with a strong balance sheet will typically have a quick ratio above 1 times, interest coverage above 3 times, and debt-to-EBITDA below 2 times. For free cash flow cover, look for at least 1.5 times.

Slight variance around those figures is fine and it’s important to compare these ratios with competitors’ ratios, as well. Most utilities will have debt-to-EBITDA ratios above 2 times and free cash flow cover close to 1, for instance, but that doesn’t mean they all have terrible balance sheets or unsustainable dividends. The regulated nature of some utility operations allows for a little more leverage. In cases like this, focus your attention on shares with the best relative metrics to the industry average.

Second, it’s important to determine how a company entered the high-yield area of the market. Because yield and share price have an inverse relationship, it’s often the case that a high yield share was a dividend growth share whose yield increased as the result of a depressed share price and not a more generous dividend policy. If this is the case, be sure you understand why the market sold off the share.

Third, there tends to be a limited number of ‘quality’ high-yield shares and they tend to be concentrated in just a few sectors. Investors should be careful not to overload their portfolios in just a few shares or sectors to maximise yield. Diversification is always important.

Finally, since high yield shares tend to be slow-growers, management teams at these companies may opt to make silly and large acquisitions in order to jump-start growth. This strategy usually means bad news for shareholders — the company overpays, can’t achieve its synergy goals, etc. — and the dividend could be at risk if the move turns out to be particularly bad. Be extra cautious around companies with the habit of making sizeable acquisitions to fuel growth.

Roll your own dividend investing strategy

One of the nice things about building an income-focused portfolio is that you can mix dividend growth and high yield shares to meet your specific goals.

If you’d like a little more current income, for example, but still have a longer-term time horizon, you might put 70% in high yield shares and 30% in dividend growth shares. The possibilities are endless.

The Analyst owns shares of SSE and AstraZeneca. You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

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‘Clean’ HSBC index funds are pretty messy

The passive investors who frequent Monevator love cheap funds like teenage boys love cheap dates. So it was with a certain frisson that I greeted the news that HSBC have fired their incredible shrinking ray at their index fund Total Expense Ratios (TER).

The TERs or Ongoing Charge Figures (OCF) have shrivelled as follows:

HSBC C Class Fund Old TER/OCF New TER/OCF
FTSE 100 Index 0.27% 0.17%
FTSE 250 Index 0.29% 0.19%
FTSE All Share Index 0.28% 0.18%
American Index 0.30% 0.20%
European Index 0.35% 0.25%
Japan Index 0.33% 0.23%
Pacific Index 0.46% 0.36%
UK Gilt Index 0.28% 0.18%

That’s Vanguard beating form.

So if you’ve already got a portfolio full of HSBC index funds (as many Monevator readers do), you’ll be reaping the reward of the lower cost shortly, right guys?

C no evil

Yeah, no. The weeny OCFs only come with a new spin-off version of the fund – the so-called C class.

The C class funds are clones of the familiar retail share class index funds used in the Slow & Steady portfolio.

The holdings are the same and the roles played in a portfolio are the same. The only differences are the 0.1% snipped off the price tag, limited availability and the backflips you need to do to calculate whether these funds are actually a good deal. We’ll come back to that in a minute.

You can spot a C class fund in your broker’s listings by the telltale C it will have in its name. For example:

HSBC FTSE All Share Index C

The ISIN numbers are different from the retail versions of the HSBC index funds so, if you want to convert to C class, you’ll need to order your broker to make the switch.

Get fresh smelling C Class index funds for average performance

C no funds

But your broker may not stock the C class funds.

The back story is that these funds are not primarily intended for retail investors. They’re designed for the likes of Independent Financial Advisors (IFAs) who need to be squeaky clean about charges once the RDR regime kicks in on January 1.

Listings by execution-only brokers seem pretty haphazard, so far I’ve found the C Class on:

  • Clubfinance
  • Interactive Investor
  • Commshare
  • Cavendish Online

The common link is Cofunds. Cofunds is a generic fund investment platform that is rebadged by brokers wishing to offer their own service. It’s a bit like discovering that all the cosy country pubs in your area are run by the same mega-brewery.

Not every Cofunds-backed broker is stocking the C class yet and HSBC are supplying other platforms too. My best advice is to call your favourite broker to see what they can do.

Sadly, the choker is that you’re unlikely to get the C class funds without having to pay extra platform charges. And these charges will wipe out the cost advantage for most investors.

C no difference

HSBC slashed the cost of the C Class by stripping out the 0.1% platform fee that is bundled up in the OCF paid for the retail versions.

Vanguard refused to pay this fee from the beginning which is the main reason why their funds weren’t sold on many platforms. It’s also why you’ll always pay a dealing fee or a platform fee (or both) to own Vanguard funds on top of the OCF.

So let’s face it, no platform that wants to stay in business is going to offer us HSBC C class index funds for free.

Platforms are going to levy an additional fee to put the C class on their shelves. The difference is that you’ll know what you’re paying, to whom and why, and that’s the whole point of RDR.

Sadly, the out-of-the-closet platform fees are considerably more painful than the hidden ones of old that nobody talked about.

Returning to our C class listing brokers:

Clubfinance – said the funds were listed by mistake. When they are made available then they will cop the following extra charges:

  • £40 annual fee
  • 0.29% on the first £100,000
  • 0.26% on the next £150,000
  • And so on, up the tiers until you’re paying a mere 0.15% after the first million
  • This is known as the Cofunds Explicit Charging Structure
  • 0.1% Clubfinance platform fee

Interactive Investor – we know all about thanks to their price rise car crash earlier in the year:

  • £80 p.a. platform fee
  • £10 dealing fee on funds
  • Some free trades available and regular purchases are £1.50

Commshare – the staffie I spoke to didn’t know anything about additional charges, but I’ve since found this on their website:

We can arrange investments in No-Trail Funds in return for a fee (typically 0.25% p.a. of the value of your No-Trail funds) charged to your CommShare Cash Account.

Cavendish Online – again, the support staff got a ‘computer said “no”’ on platform charges but the website makes it clear that investors will be hit by Cofund’s explicit charging.

Best case scenario

Most small investors are clearly better off sticking with the regular retail HSBC index funds and a no-fee broker.

The C Class funds only work if you can reduce the explicit platform fees to less than 0.1% of your assets.

So if you’ve got over £90,000 in HSBC index funds and can restrict your trading fees to £10 per year then the C Class will just edge it at Interactive Investor.

Where the C Class index funds butt up against Vanguard there’s now very little difference in OCF. The game essentially comes down to who can offer the cheapest platform fees.

There is another one

HSBC themselves offer the only faint hope of a clear cut winner, if they decide to sell the C class funds directly to investors sans platform fee.

Monevator reader and MSE forum Sensei, Snowman, has been tipped off that this could happen from mid November.

I tried to confirm this with HSBC but was told only that the C Class would be made available through their Global Investment Centre by January 1 and that charges are still being worked out.

So who knows? Not the HSBC frontline staff, anyway.

Take it steady,

The Accumulator

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Weekend reading: Unpicking on Warren Buffett’s alpha

Weekend reading

Good reads from around the Web.

Regular readers will know I am that rare thing: a largely active investor who really should know better.

That’s why we have a big passive investing section here on Monevator, and why I suggest most readers direct most (or all) of their money towards passive portfolios.

That doesn’t mean I don’t think some individual investors – or fund managers, for that matter – won’t beat the market. In fact, I see no theoretical reason why some shouldn’t.

But that is a long way from saying I think you will, or that I will.

And it’s even further from saying that you can identify, in advance, a fund manager that can beat passive funds over the long-term – by a sufficient margin to pay for his or her costs, of course.

Just because something is possible – or even certain – doesn’t mean you should do it.

I guarantee you that someone will win the National Lottery tonight.

But I don’t think you should you put your life savings into lottery tickets.

Deconstructing Warren Buffett

Warren Buffett is one indisputable market beater, as far as I’m concerned.

Yet the lengths that some will go to in order to explain away his extraordinary success is, well, extraordinary.

Last week I included a link to an Economist article about some academic research that put Buffett’s out-performance mainly down to leverage (that is, cheap financing from Berkshire’s insurance float).

Never mind that Buffett was hammering the market for years before he had such leverage (in fact he was doing much better when he ran a smaller pool of money).

Like back-testers the world over, the wonks behind the paper didn’t let a little thing like dates and circumstances get in the way of their grand theory.

Anyway, I’ve now had a chance to read the full Yale paper, thanks to Monevator contributor The Analyst who sent over that link to the PDF.

In it the academics – with hindsight, obviously – apply half-a-dozen or so factors to Buffett’s results to ‘explain’ why he outperformed as a stock picker, on top of the gains he made by leveraging.

They even go so far as to create a synthetic Buffett screen, which they then apply back to several decades of market data, and say it would have done just as well as Buffett himself!

Newsflash: It’s not hard to see what someone has done, and then say that if anyone did it, they’d have got the same result.

To be fair, the academics several times that they consider Buffett’s talent to be exceptional – they point out that he executed their strategy 50 years before the academic underpinnings of their mimicking filters were widely accepted.

But that hasn’t stopped some pundits proclaiming that Buffett has been decoded, that you can replace him with a share screen, and that we might soon see ETFs that deliver what Berkshire did.

Which I think is a bit silly.

Buffett: Human, after all

If any active investor has an edge, then almost by definition it can’t be replaced with a screen or a mechanical strategy.

Even more importantly, Buffett himself was a living, breathing businessman who several times changed course as an investor over his six-decade long career. He went from Ben Graham ‘cigar butts’ to private companies to blue chip brands to buying mega-railroads.

Only this year he said he’d rather be buying residential real estate!

So I don’t think a mechanical ‘robo-Buffett’ would have a hope in hell of predicting what a real Buffett would do if he were to live to 140 and invest for another 60 years.

Unpicking Buffett’s edge as an academic activity is one thing – leaping to the conclusion that you can build and buy a Buffett ETF is quite another.

[continue reading…]

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Monevator Private Investor Market Roundup: October 2012

Monevator Private Investor Roundup

I’m very pleased to welcome back RIT, with his latest roundup of the past three months’ movements in the most important asset classes. When not generously crunching numbers for Monevator, he runs Retirement Investing Today. Take it away RIT!

There have been some big moves over the past quarter in many of the markets we track – markets that we’ve chosen to help us understand our portfolios’ moves, and maybe to flag up a bargain!

These latest market shifts might have been caused by:

  • Mario Draghi, the ECB president, telling us he will do “whatever it takes” to save the Euro.
  • Ben Bernanke, US Fed chairman, announcing QE3. (Or should that be QE Infinity? I can’t find a reference to any eventual limit to the $40 billion that Bernanke will create every month to buy mortgage-backed securities).
  • No new UK government initiatives to support house prices, other than Nick Clegg’s proposed pension for property plan.
  • UK company earnings falling – by my calculations they look to be down about 7% quarter-on-quarter.
  • Poor wheat harvests in the UK and US, as well as drought in the US leading to a predicted 30% drop in the soya bean harvest.

I definitely don’t claim to know everything that might be moving the markets (more the opposite!) so if you’d finger any other macro events that occurred over the past quarter, please do share them in the comments below.

Disclaimer: I must point out that what follows is not a recommendation to buy or sell anything, and is for educational purposes only. I’m just an Average Joe and I’m certainly not a Financial Planner.

Your first time with this data? Please refer back to the first article in this series for full details on what assets we track in the Private Investor Market Roundup, and how and why.

International equities

Our first stop is stock market information for ten key countries1.

The countries we highlight are the ten biggest by gross domestic product (GDP). They also represent the countries that a reader following a typical asset allocation strategy will probably allocate most of their funds towards.

Here’s our a snapshot of the state-of-play with each country:

(Click to enlarge)

The prices (i.e. the various stock market levels) shown in the table are the FTSE Global Equity Index Series for each respective country, taken on the first possible day of each quarter.2 The prices in the table are all in US Dollars, which enables like-for-like comparisons across the different countries, without having to worry about exchange rates between them.

The Price to Earnings Ratio (P/E Ratio) and Dividend Yield for each country is as published by the Financial Times and sourced from Thomson Reuters. Note that these values relate only to a sample of stocks, albeit covering at least 75% of each country’s market capitalisation.

Here’s a few interesting snippets:

  • Best performer: In price terms Germany is the best performer, both quarter-on-quarter and year-on-year, rising 12.9% and 29.1% respectively.
  • Worst performer: Japan took this dubious honour. The stock markets of all the other countries we track are up nominally both on a quarter-on-quarter and year-on-year basis. But Japan saw small falls of -2.1% and -1.3% respectively.
  • P/E rating: Italy saw big P/E increases, up 26.2% on the quarter and up 62.1% on the year. This comes on the back of its market rising over those periods by 7.5% and 3.4% respectively – a disparity that tells you that the earnings of Italy’s companies are falling fast. Japan saw its P/E drop 2.1% quarter-on-quarter, but rise 2.2% year-on-year.
  • Dividend yields: If you’re saving for the long term, whether it be for retirement or some other long term goal, dividends matter. Italy currently has the largest dividend yield at 4.4%. However this is down 10.2% on the quarter. France also saw its dividend yield fall – it’s down 17.4% on the year.

Remember that – all other things being equal – falling prices increase dividend yields. So rising yields aren’t necessarily good news for existing holders, since they usually indicate prices have fallen.3 A higher yield might indicate a more attractive entry point for new money, however.

With Francois Hollande’s socialist government in France recently announcing an additional EUR10 billion of taxes on business in 2013, we could see dividend payouts cut, and hence dividend yields potentially fall further in that country.

Of course, French share prices could also fall to compensate. That’s because instead of EUR10 billion of earnings going to either company re-investment, which could help French shares in the longer term, or else being returned to the shareholder as dividends, we will instead see the money simply siphoned off to the French government.

The largest increase in dividend yield came from Russia, where the yield was up 5.1% quarterly and 57.7% yearly. This is an usual case, where the large increase in yield has come about because of far higher dividend payouts from Russian companies – at the urging of President Vladimir Putin.

Longer term equity trends

To see how our ten countries are performing price wise over the longer term, we track what we call the Country Real Share Price.

This takes the FTSE Global Equity Price for each country, adjusts it for the devaluation of currency through inflation, and resets all of the respective indices to 100 at the start of 2008.

Here’s how the countries have performed since then, in inflation-adjusted terms:

Graph showing our country-specific real terms share price index

(Click to enlarge)

The graph reveals that in real (inflation-adjusted) terms, not one of the countries we follow has yet seen its stock market rise to new real highs.

The US is closest at 92.7. Italy has done the worst, at 32.6.

Spotlight on UK and US equities

I couldn’t talk about share prices without looking at the cyclically-adjusted PE ratio (aka PE10 or CAPE). If you’re not familiar with it, you can read more about the cyclically-adjusted PE ratio elsewhere on Monevator.

The charts below detail the CAPE4, the P/E, and the real, inflation-adjusted prices for the FTSE 1005 and the S&P 5006.

(Click to enlarge)

 

(Click to enlarge)

Some thoughts:

  • Today the S&P500 P/E (which includes some estimates) is at 16.2, while the CAPE is at 21.5. This compares to the CAPE long run average of 16.5 since 1881. This could suggest the S&P500 is overvalued by 30%, which is up slightly on last quarter’s overvaluation estimate of 29%.
  • The FTSE100 P/E (again using as reported earnings) is 11.2 and the CAPE is 12.0. Averaging the CAPE since 1993 reveals a figure of 19.2. This could suggest the FTSE100 is undervalued by 37%.

I personally use the CAPE as a valuation metric for both of these markets, and use the CAPE data to make investment decisions with my own money. I put my money where my mouth is!

On the other hand, some investors are skeptical about the usefulness of the CAPE.

House prices

A house is the largest single purchase that most Monevator readers will ever make. Property is also a big influence on other sectors of the economy, and rising prices are seen as a key ingredient in the so-called ‘feel-good factor’ (although those shut out by higher prices might feel less jolly…)

For this roundup, I calculate the average of the Nationwide and Halifax house price indices, as follows:

(Click to enlarge)

If you don’t already own a home, the quarterly news is all good, with prices down 0.9%. Annually the news is also good – prices over the year are also down 0.9%.

If you own a property, you’re probably not so thrilled.

The next house price chart shows a longer-term view of my Nationwide-Halifax average. I adjust for inflation, to show a true historically-leveled view:

(Click to enlarge)

In real terms, house prices continue to fall. House prices are now back to approximately February 2003 levels.

In my opinion these nominal and real falls are good news. I believe the market is still-overvalued, although I’m sure the majority of the British public don’t necessarily agree.

If falling prices continue (or even accelerate) we might one day see the UK property market return to normality, with sensible transaction volumes and first-time buyers able to enter the market without schemes like the Lib Democrats’ ‘pension for property’ scheme that I mentioned earlier.

Nick Clegg’s scheme is in my opinion just another lame attempt to shore up the property market. If it goes ahead, my feelings go out to those unfortunate first-time buyers who either don’t have parents, or whose parents don’t have a pension pot to raid. I just wish the UK government would leave the property market well alone.

I’ll stop there or this could turn into a rant. I can get away with that on my own blog, but I’m sure The Investor won’t let me get away with it on his!

Commodities

Few private investors trade commodities directly. However commodity prices will still affect you, and your investments.

With that in mind, I’ve selected five commodities to regularly review. They are the top five constituents of the ETF Securities All Commodities ETF, which aims to track the Dow Jones-UBS Commodity Index.7

(Click to enlarge)

Quarter-on-quarter we see soya bean prices rose a substantial 19.6%, and annually we see them up 24.2%. Natural gas also saw some big moves, up 16.6% on the quarter, but down 30% annually.

My preferred commodity for investment purposes is gold. That’s not because I’m a gold bug, but because I don’t want to worry about contango/backwardation, and because I don’t own (and don’t want to pay someone who does own) a tanker, silo, or a large warehouse!

Gold is down 7.4% year-on-year.

Real commodity price trends

Much as I did with equities, I have created a Real Commodity Price Index that we can track over the long-term.

This index looks at commodities priced in US dollars, is corrected for inflation so that we can see real price changes, and resets the basket of five commodities to the start of 2000.

(Click to enlarge)

You can see that gold continues to be the star performer since 2000 – it’s up over 400%. On the other hand the under-performer, natural gas, remains below par at 86.5.

Wrapping up

So that’s the second Monevator Private Investor Market Roundup. I hope it’s given you a small insight into the market’s trials and tribulations over the previous quarter. As always it would be great to hear your comments if you have anything to share.

Finally, as I always say on my own blog, please Do Your Own Research.

For more of RIT’s analysis of stock markets, house prices, interest rates, and much else, visit his website at Retirement Investing Today.

  1. Country equity data was taken as of the first possible working day of each month except for October 2012, which was taken on the 28 September 2012. []
  2. Published by the Financial Times and sourced from FTSE International Limited. []
  3. High yields can also indicate higher dividend cash payouts by companies, which act to increase the yield even if the price stays the same. []
  4. Latest prices for the two CAPEs presented are the 28 September 2012 market closes. []
  5. UK CAPE uses CPI with September and October 2012 estimated. []
  6. US CPI data for September and October 2012 is estimated. []
  7. The data itself comes from the International Monetary Fund. []
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