Good reads from around the Web.

A post of the week. Here’s Josh Brown at The Reformed Broker warning about an inevitable crash in the bond market:

I’m going to say this here and now for posterity and I hope you bookmark it:

There’s going to be such a brutal bond investor slaughter at some point over the next decade that the streets of Boston’s mutual fund district will run red with blood, the skies will be shot through with the lightning and thunder of unexpected capital losses and those who manage to survive will envy the dead.

Now a slaughter in bonds will not look like an equity market crash, the volatility characteristics are different and bonds eventually mature. But in some ways it will feel much worse than a stock crash because the money parked in bonds is thought of as low or no-risk.

The fixed income guys know what’s going to happen, too. Why do you think the Bond Kings at PIMCO and DoubleLine are pushing into equity funds? They’re getting three-year track records under their belts for when the big switch comes.

One reason Josh Brown is an excellent writer and pundit is because he doesn’t prevaricate. It may not be good advice – I have no idea about his track record, either way – but it grabs you right in your special interests.

In contrast, while I happen to think Brown is likely right about bonds, I’d feel duty bound to caveat it with warnings about deflation, Japan, market timing, and 20-year bear markets.

In fact, I already did. Some of my readers may have ended up wiser for it, but I suspect a few of them ended up asleep.

Brown’s is the strategy of a Wall Street professional. If he’s right, he can point to his prediction for years to come. If he’s wrong, nobody will ever remember – maybe not even Josh Brown, thanks to hindsight bias.

Perhaps even Google will forget his page eventually.

It’s a great post – and I think likely a good call – but it’s not necessarily correct.

[continue reading…]

Once you have established a solid foundation of dividend knowledge and understood the differences between the various types of dividend shares, you are ready to start prospecting for potential income investments.

Today I’ll discuss how you can get started in the dividend research process.

Panning for golden ideas

Poring over each of the 600-plus companies listed in the FTSE All-Share index to identify a few promising ideas is an arduous and time-consuming task.

Fortunately it’s a task that’s been rendered unnecessary by one of the most glorious by-products of the Internet: the share screener tool.

The primary purpose of a share screener is to reduce the vast number of potential portfolio candidates to a handful of names that you can research further.

You simply enter a few key parameters and the screener displays the select companies that fit your chosen attributes.

One important point to make right away is that screener results should not be considered automatic buy lists. Further research is always necessary, as screener results don’t always tell the whole story. (In the next two articles, we’ll discuss this process for researching individual shares.)

A number of helpful screening tools are available to UK investors online, including:

Free screeners:

• Telegraph Stock Screener
• Digital Look
• Morningstar

Premium screeners (i.e. not-free)

• Stockopedia
• Sharelockholmes
• Company REFS

If you’re just starting out, the free screeners will do the trick. More experienced investors may want to try the premium screeners, but for our purposes here we’ll just use the free screening tool from The Telegraph.

How to screen for high yield shares

In the previous article in this series, we defined ‘high-yield’ shares as shares with dividend yields between 1.2x and 2x the market average.

With the FTSE All-Share average yield currently near 3.6%, we can begin screening for high yield shares by entering 4.2% to 7.2% into the ‘dividend yield’ parameter about two-thirds down the screener page.

If you try this dividend yield range in a share screener tool, however, you’ll find that you get a list of several dozen companies in the results. For a more manageable hit list of potential high yield investments, we’ll need to enter a few more parameters into the screener to further narrow our search.

With high-yield shares, dividend sustainability is more important than growth potential — a high yield does us little good if the payout gets cut in the subsequent year — so the extra parameters will be designed to help us identify companies with the ability to maintain their current dividend and ideally grow it each year.

To identify high-yield shares that are likely to maintain their payouts in the coming years, we can enter the following five parameters:

• Index: FTSE All-Share. Whilst there may be good opportunities among AIM-listed shares, most investors will want to hold their dividend shares within the tax shelter of an ISA. They’ll therefore need to own LSE-listed shares and to avoid AIM-listed shares.

• Return on equity > 10%. Companies that are unable to consistently generate returns on equity above 10% are likely destroying shareholder value. Even though high-yield companies aren’t usually high growth companies, we nevertheless want to own shares that are at least earning their cost of equity each year. Searching for companies that generate at least 10% return on equity is a fair place to start.

• Dividend cover > 1.2 times. The Telegraph share screener tool does not have free cash flow cover, but the earnings-based dividend cover will do for now. (We’ll discuss calculating free cash flow cover in the next article.) Another way to think about this metric is that a company with 1.2x dividend cover is paying out 83% of its earnings as dividends (1/1.2). This is the absolute minimum amount of dividend cover that investors should demand when researching high-yield shares, in my opinion. Without the ‘margin of safety’ afforded by a well-covered dividend, a year or two of lower earnings could force the company to reevaluate its dividend policy.

• Five year turnover growth > 0%. Sales are the life-blood of the financial statements, so companies with declining turnover may be steadily shrinking. Companies in a state of secular decline usually feel pressure to take drastic actions to maintain profitability, such as a large merger or massive restructuring plan. Those situations can be messy and all else being equal we want to avoid getting entangled in them, because dividends can come under the chopping block in an effort to boost cash flows.

• Five year EPS growth > 3%. Similarly, we also want to see at least a little growth in earnings per share. A situation where a company’s EPS is contracting whilst dividends per share are growing is simply unsustainable. Eventually the dividend will come under pressure. Because we want our high-yield shares to grow at least modestly in the coming years, we want to see a recent track record of positive EPS growth.

By adding these five parameters, we get a much more manageable list of shares to research:

Though we still have some work to do — particularly on valuation — the screen has helped us identify some promising high-yield research candidates. My next article in this series will discuss how to further research high-yield shares once you’ve found them via a screen.

Screening for dividend growth shares

To screen for ‘dividend growth’ shares that may have lower starting yields but have more potential to grow future payouts at high rates, we simply need to make a few adjustments to our screening parameters.

Since we’ve previously defined dividend growth as shares between 2% and 1.2 times the market average, we’ll change the dividend yield range to 2% to 4.3%.

We’ll again stick with just FTSE All-Share stocks in this screen to make sure they are ISA-eligible.

Here are a few more settings:

• Return on equity > 15%. Companies that consistently generate returns on equity over 15% likely have some type of sustainable competitive advantage. Otherwise, you would expect competitive forces to drive ROE downward to the company’s cost of equity. Although ROE does have some flaws (which we’ll discuss in the next article), screening for companies with ROEs over 15% give us a better chance of finding shares with the ability to produce high rates of return.

• Dividend cover > 1.5 times. When looking for dividend growth ideas, we should demand more dividend cover than in the case of high-yield shares for two reasons. First, because we want to identify firms with higher growth rates than high-yield shares, we naturally want these companies to retain a meaningful amount of profit each year to reinvest in the business to promote sustainable longer-term growth. Second, by starting with a higher dividend cover ratio, we’re giving dividend growth shares the potential to grow into a lower dividend cover as they mature. A dividend growth share that’s consistently paying out 90% of earnings today, for instance, doesn’t have much room to augment its payout ratio as growth slows and is thus primarily dependent on earnings growth to deliver dividend growth.

• Five year dividend per share growth > 7%. Just because a company may have the financial strength to increase its dividend at a high rate, it doesn’t mean that the company’s board will do so. For instance, the board could prefer to employ share repurchases or engage in aggressive M&A rather than pay out free cash as dividends. By identifying shares with a track record of raising dividends, we stand a better chance of avoiding companies not fully committed to their dividend programmes.

• Five year EPS growth > 7%. Whilst companies can artificially boost earnings per share using buybacks, most corporate boards of directors use EPS-based payout ratios when determining dividend policy. If the board is seeing strong EPS growth, then they’re more likely to boost the dividend at a similar pace.

As you can see, we have plenty of good ideas to research and from a variety of sectors, too, including financials, commodities, consumer goods, and technology.

We’ll take a closer look at this list of dividend growth ideas after we discuss high yield shares in the next article.

Still more to do

Share screening tools have greatly simplified what was once a time-consuming task of idea-generation. Nevertheless, a successful screen is just one part of a complete research process.

Over the course of the next two articles, we’ll discuss how to use screener results to select the best of the best ideas.

In the meantime, why not try your hand at a few screens and see how they can work for you? And if you have any of your own screening tips, please share them in the comments box below!

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

A number of fledgling investors have been wondering whether they should postpone their first plunge into investing because of the upheaval caused by the Retail Distribution Review (RDR), going by the chatter we hear in the Monevator comments and across the forums.

Even some seasoned DIY investors appear to be paralysed by the platform fee buboes that keep bursting out on their execution-only brokers.

Switching brokers is possible, of course, but it equals hassle, pain, and expense.

It’s enough to make you stay in cash. Don’t let it!

RDR 2: The FSA Strikes Back

For starters, the new rules on platforms aren’t due to come into force until we’re partying like it’s 2014.

• RDR Part One ends hidden payments to Independent Financial Advisors (IFAs) on 31 December, 2012.

• RDR Part Two is going to kybosh stealth payments to platforms by 31 December, 2013.

If all goes according to plan, platform fees will be deducted in plain view from our cash accounts, rather than being sneakily siphoned off via a fund’s Ongoing Charge Figures (OCF).

The idea is that explicit charging will sting, and so cause us to ask searching questions about levels of service.

But the Financial Service Authority (FSA) is still pondering over the final draft of the rulebook. It hasn’t given a precise date for a decision. It may still change its position or delay RDR Part Two altogether. It has form.

What’s more, the FSA is itself going to be abolished and replaced by new authorities – supposedly in early 2013.

It may well feel like the last week of school in there.

Every day counts

Let’s say it takes another year for the FSA – or its successors – to pronounce a verdict, for the platforms to fully respond, and for the dust to settle on a new pricing landscape.

The FTSE All-Share has gone up 13% in the last 12 months. Assume, for the sake of argument, this performance is repeated over the next 12 months.

As a newbie investor, even with only £500 invested, you’d still be up on the £50 or so it would cost to transfer to a new platform with a couple of funds in your portfolio, should you choose to invest now and move if you need to later.

I’m not pretending I know the market is bound to soar over the next 12 months. It could just as easily crash, or flatline like an Ed Miliband joke.

But either way it’s a mistake to allow a minor detail like saving a few quid on platform fees to be the tail that wags your investing dog.

Dithering could cost you the few days in the year that the market goes on a tear. And if your platform proves uncompetitive then transferring out isn’t the end of the world.

Of course, if you’re getting cold feet for some other reason, then that’s perfectly understandable…

Known unknowns

An upheaval like RDR risks more unintended consequences than traveling back in time and chatting up your nan.

Here’s a few of the potential googlies that could keep investors on the hop for a long time yet:

• RDR may run foul of the EU’s decision not to ban commission in its MiFID II review. That leaves open the possibility of European platforms selling funds to UK investors while eluding the clutches of RDR.

• Some execution-only brokers will slip through the loopholes created by the FSA’s definition of a ‘platform’. These brokers may well be able to rebate commission in cash with the FSA’s blessing. A final decision has yet to be made.

• The FSA is also considering allowing platforms to rebate fees as units rather than cash. In other words, they might compete by offering us bonus shares in our funds.

That last one beggars belief, as the FSA has already expressed the view that trail commission is used by fund providers to buy preferential marketing treatment on platforms.

If rebates still exist in any form then that practice is likely to continue by another name.

What to do now

Of course, none of this pondering solves the problem of finding a good home for your investments today.

My best suggestions for no-fee or low fee brokers can be found here. You can partially prepare for the future by choosing a platform that’s already declared its hand on RDR.

Remember the answer to any investing question is about as straight as a journalist in front of the Leveson inquiry, but for passive investors who want to buy index funds in an ISA:

• Cavendish Online – Claims its no-fee model is likely to survive RDR. It charges nothing bar the TER. You can’t buy ETFs though, should you fancy it.

• TD Direct Investing – No charges if you have over £5,100 in your portfolio. Otherwise it’s £36 a year. No dealing fees for funds.

• Selftrade – Beats TD Direct if you’ve got less than £5,100 and will definitely trade once per quarter. Otherwise the inactivity fee is £10 per quarter. Funds are free to buy, but not to sell.

• Hargreaves Lansdown – Platform charges are £24 per fund per year. No dealing fees. It makes sense if you want a portfolio consisting of one or two funds you can’t get from the first three platforms (e.g. Vanguard LifeStrategy).

• Alliance Trust – Platform fees are £48 per year and you can buy funds at £1.50 if you make regular investments. Beats Hargreaves Lansdown if you want Vanguard, hold more than two funds, and make eight or fewer regular purchases a year. Otherwise look at Bestinvest.

Note, I haven’t exhaustively searched all 100-odd execution-only brokers in the market. I gotta go eat soon. But this is an informed snapshot. If you can find a better RDR-friendly deal then please let us know in the comments below.

Finally: More Vanguard options

It’s also worth mentioning when choosing platforms that the Vanguard funds will now be much more widely available, as it has struck a deal to appear on Cofunds – the platform that lies behind many broker’s online convenience stores.

Platform fees will apply, potentially along the lines of Cofunds’ Explicit Charging Structure, which amounts to a £40 annual fee plus 0.29% on the first £100,000. That will be a mighty wallop if your platform doesn’t cap it.

So that’s the long of it. The short of it is: it’s a mess but don’t let RDR put you off the investing fun. Monevator will be here to help keep you up to speed.

Take it steady,

The Accumulator