After five years of record low interest rates, growing numbers of income investors are turning to the stock market. Their logic: dividends from solid blue chips offer a better prospect than the derisory returns available from bank and building society accounts.
That said, following some simple guidelines can help investors to avoid dividend duds. In particular, unlike banks and building societies, where the name of the game is to find the highest-yielding account, it’s best to avoid those shares that offer the very highest dividend yield.
Why so? Because the dividend yield — the ratio of the dividend to the share price — might be high because investors have marked down the share price in anticipation of bad news.
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So a dividend yield that looks tasty today, could quickly turn sour tomorrow.
Safe bets
No company is immune from periods of difficult trading conditions. Even the stellar 25-year performance of Tesco has faltered in recent years, prompting the company to hold its dividend steady for three years.
So when looking for shares for my own income portfolio, for instance, I try to apply three simple tests. They won’t turn a share pick into a sure-fire bet — no test will do that — but they can turn a share pick into a safer bet.
- Has the company a track record of delivering year-on-year increases in its dividend?
- Better still, has it a record of delivering recent year-on-year percentage increases in the dividend growth it delivers?
- Is the dividend amply covered by earnings?
Such companies are a much, much better bet than a business that happens to be offering a high yield simply because its share price has slumped.
Four to ponder
At present, I’m certainly attracted by the dividend growth prospects of these four solid and widely diversified blue chips — two of which I already hold a stake in.
|
Company |
Four-year dividend growth |
Forecast yield |
|---|---|---|
|
AstraZeneca (LSE: AZN) |
8.2% |
4.5% |
|
BHP Billiton (LSE: BLT) |
9.2% |
4.0% |
|
British American Tobacco (LSE: BATS) |
12.8% |
4.6% |
|
Legal & General (LSE: LGEN) |
18.1% |
5.7% |
Better still, the beauty of shares exhibiting dividend growth at these sorts of levels is that you can use the handy ‘Rule of 72′ to see how long it will take to double your income.
Take 72 and divide it by the expected growth rate — 12%, for example, in the case of the average annual dividend growth over these four shares. Divide 72 by 12 and you get 6 ‑‑ telling you that it will take roughly six years to double the dividend.
So a dividend of 15p per share today, for instance, will be 30p per share in six years’ time — plus, of course, any capital growth delivered through a rising share price.
All for sitting back, being patient, and enjoying an average yield that — at 4.7% — is already comfortably ahead of what you’d get from a bank or building society.
A growing income
Which, of course, underscores just why so many income investors are turning to the stock market and plumping for decent, dividend-paying shares. It’s what I’m doing myself, for instance, building up a steady stream of income from companies such as Royal Dutch Shell, GlaxoSmithKline and Unilever.
Handily, too, if held inside an ISA or SIPP, then those dividends are free of any further taxation. And better still, with shares held directly, there’s no fund manager to pay.
But which shares to buy? And which companies have the makings of a decent, dividend-paying share that can deliver solid returns for 10, 20 or 30 years?
