How to be a successful income investor in 2016

The US Federal Reserve’s decision to move headline American interest rates higher for the first time in nearly 10 years begs three important questions:

• First, what will the degree and pace of any further increments be?
• Second, will the Bank of England start to follow suit and increase returns on cash here?
• Third, what are the implications for higher rates for income hunters and therefore income stocks and funds?

In order, the answers may be as follows:

• The Fed’s own forecasts point to four more, one-quarter point increases in 2016, taking the target rate to 1.5%. However, the market seems sceptical and looks to be pricing in no more than two, given chair Janet Yellen’s comments last week about a shallow trajectory to the rate cycle and the US central bank remaining data dependent.
• Governor Mark Carney has flip-flopped around so much no-one really knows what he’s thinking but the market does not expect the first quarter point increase from the current historic low of 0.5% until the second half of 2016 at the earliest.
• Usually, rising interest rates are seen as a negative for income stocks, or so-called bond proxies. The theory is that higher interest rates mean investors can dump higher-risk sources of income like stocks and shares and retreat to the relative safety of cash. Sure enough, classic fat-yielding sectors like Electricity, Gas, Water & Multi-Utilities and Mobile Telecoms have done relatively poorly this year but those stodgy sectors rallied last week, again based on the view that future rate rises will be slow and steady.

Even if UK interest rates double in 2016 that will take them to 1%, a figure which hardly represents rich pickings and for now it does seem unlikely that interest rates are going to zoom higher on either side of the pond: there’s too much debt around and growth is fragile so central banks are unlikely to over-do it. 

We still seem to be stuck in a low-inflation, low-interest-rate and low-growth world. As such many investors will still be seeking income to try and generate some dependable returns on their cash. In this scenario, there are two options, at least when it comes to the stock market:

• If you are a do-it-yourself stockpicker, you must tread carefully and do your own research as there are few worse investments than an income stock that cuts its dividend: your yield disappears and the share price takes a beating, doubling your woes. History shows you actually tend to be better off buying a stock with a yield of 3% to 4%, good cover and potential to grow than buy one with a yield north of 5% with skinny cover that the firm has to work hard just to protect, as the latter dividend could actually be in danger. The past is no guarantee for the future but this is a rule of thumb to bear in mind.
• If you do not have the time, expertise or patience for all of this research, then an equity income fund is an option to consider, albeit in the knowledge the fees charged by the money manager will erode some of your yield. There is a whole range of crack money managers who dedicate themselves to running funds that provide income from stocks and it’s their job to pick the winners and avoid the cutters and losers. There is a wide selection of both open-ended (OIECs) and closed-ended (investment trusts) collectives. The tables below show the best performance in the UK equity income space over the past five years.

Best performing UK Equity Income OEICs over the past five years

Source: Morningstar, for UK Equity Income category.
Where more than one class of fund features only the best performer is listed.

Source: Morningstar, The Association of Investment Companies, for the UK Equity Income category. * Share price. ** Includes performance fee

If you think actively-managed funds are too expensive and performance hit-and-miss, you can buy a passive fund, or exchange-traded fund (ETF). These can track well-known indices such as the FTSE100 but some ETFs now track tailored indices, especially created for the job. Some of these so-called “smart beta” products are designed to follow a carefully screened group of income-generating stocks, selected for their yield-paying potential. One such example is iShares UK Dividend, which is one of the sixteen Top Trackers used by AJ Bell’s Guided Investment Service. 

iShares UK Dividend has a 0.4% ongoing charge figure, well below the fees levied by actively managed funds, and a five-year trading history, although competitor products have been around for a lot less. Amundi ETF FTSE UK Dividend Plus has been around for over three years while Wisdom Tree UK Equity Income and BMO MSCI UK Income Leaders launched in 2015.

Rules of the game

Generating income sounds easy to some stock market investors: pick a stock with a fat yield and off we go. Unfortunately it isn’t as simple as that as 2015 shows, because no fewer than eight FTSE 100 firms have either cut, passed or hinted they will cut their dividend payment to shareholders. 

The list comprises Anglo American, Centrica, Glencore, Morrison, Rolls-Royce, Sainsbury, Standard Chartered and Tesco. All bar one of them have been horrible performers, inflicting not only loss of income but actual capital losses as well, as their share prices have fallen hard – and these are some of the most high profile, widely analysed companies on the UK market. Morrison’s even dropped out of the FTSE 100.

How the dividend cutters share prices have fared over the past 12 months

Source: Thomson Reuters Datastream

Before the cuts, some of these firms were offering dividend yields in the 6% to 10% range, which looked good on paper, only for this to prove to be a terrible trap for the unwary. The lesson here is any dividend yield north of around 5% right now needs to be thoroughly checked out, because in the current low-growth, low-interest rate environment it just could prove too good to be true.

Safety check

It is therefore vital to test how safe a dividend may be and one quick way of doing this is to look at earnings cover. This is calculated as follows: earnings per share divided by dividend per share.

In a perfect world the score is over two – and on average over the last eight years and the next two ina best case, not just for the coming year. There are exceptions, although there are not many – you tend to be looking at industries where demand and cashflow are stable like tobacco or utilities.

According to consensus analysts forecasts there are 21 FTSE 100 stocks offering a dividend yield of 5% or more for 2016, based on the share prices we can see at the end of December 2015. The experiences of this year suggest this may not be a credible figure and the chart shows the top 10 dividend yields as of 19 December (the bars) and then the earnings cover (the line).

Dividend cover looks skinny at the FTSE 100’s highest yield stocks

Source: Digital Look, analyst consensus forecasts

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It is not an entirely reassuring picture.

• Of the 10, only Carnival exceeds 2.5 times, although SSE at 1.3 times has the benefit of being a stodgy utility.
• The oils, BP and Shell around 1.0 times should get away with it if oil rebounds – although that’s a big ‘if’ at the moment. They can also pay dividends from their own resources while they wait for oil to rally as they have relatively little debt and are cutting both costs and investment but care is needed here. BP has cut its dividend twice since 1990, though Shell has not done so since at least 1945.
• HSBC at 1.5 times, Pearson at 1.2 times and Aberdeen at 1.2 times must all be watched very carefully
• The ones which on paper look to be at greatest risk are BHP Billiton at 0.4 times and Rio Tinto and GlaxoSmithKline at 1.0 times, especially as miners like Glencore and Anglo American have already slashed their pay-outs.

Wishing you a prosperous 2016

Skilled fund managers are paid to pick the dividend raisers and dodge the potential pay-out cutters. You can learn a lot from their top-ten holdings’ list, which stocks and sectors they like and which they do not. These lists can be found on the AJ Bell Youinvest website on a fund-by-fund basis.

As a final point, income investing is a patient person’s tactic. It works best over five, 10, 20 years or more, so income stocks and funds aren’t just for Christmas - they’re for life. And on that note, in the last of these columns for 2015, may we wish you a merry Christmas and a very Happy and Prosperous New Year.

Russ Mould

AJ Bell Investment Director