For our own good, we need to change how we think about high-yield dividends.
Income investors love dividends. Even those used to cash savings accounts or bond interest have developed a soft spot for them since 2008. Admittedly, a lot of them have been forced to climb the risk scale into the world of equity income since the financial crash because of record low interest rates.
UK interest rates are at record lows.
But the mistake is thinking dividends only matter to income-seekers.
An initial £10,000 invested in the S&P 500 over the 60 years from 1960 to 2020 would have grown to $627,161 in price terms, or $3,845,730 with dividends reinvested.
Dividends are insanely important to the value of total returns.
According to Hartford Funds, from 1970, 84% of the total return of the S&P 500 Index can be attributed to racking up dividends and reinvesting them for the long-term.
UK dividend stock top picks
So just choose the US and UK shares with the highest dividend yields, right?
Here are the current top UK dividend stocks on the FTSE 100. But, and it’s a big but, which ones will actually manage to pay that dividend? And which ones can pay it year in, year out?
|Company||Sector||Annual Dividend Yield|
|British American Tobacco||Tobacco||7.9%|
|Evraz||Metals & Mining||7.8%*|
Source: Dividenddata.co.uk, April 2021. *Indicates the company has made a dividend cut to the most recent dividend or has stated the next dividend will be cut. Past performance is not a reliable indicator of future returns.
That high number can be misleading. To understand why let’s look at exactly what a dividend yield tells us.
If a firm opts to pay a 5p dividend and currently has a share price of 100p, its yield is 5%.
But if that firm’s share price drops to 50p, that 5p dividend now becomes 10%. That might have income-seekers licking their lips but why has the stock fallen by half?
For whatever reason, is its ability to pay the dividend now diminished? Quite often that’s the case. High yields can be a signal for problems elsewhere in the business.
And even if a firm can stretch itself to pay that dividend it might not be the best option for shareholders in the end. Will it be able to pay a consistent dividend next year or is it simply kicking the problem down the road?
Imperial Brands recently announced a dividend cut to allow the firm to address its debt pile.
Financial results at Evraz have been heavily dependent on a rebound in steel prices. Any weakness in the price of the commodity this year could have a big impact on earnings and, in turn, the dividend.
And Persimmon will need some solid profits to take care of its dividend yield of over 7%.
The housing sector has been the beneficiary of huge governmental support through stamp duty incentives and the Help to Buy scheme. If that scaffolding disappears, so might profits.
None of this is to dismiss the merits of any of these firms. But a very high dividend yield, above around 7%, can be a red flag for investors and should at least prompt you to ask if the firm can pay it or not.
Quite often, a bit of research can make that prospect look a bit shakier than it first appears.
The best dividend stocks are the ones that actually pay out
If you are factoring dividends into the overall growth of your stocks, or if you are relying on it for regular income – in retirement for example – the sustainability of that payout is key.
That element of consistency is immensely important, more so than offering an eye-catching headline yield that might burn out quickly or get cut.
Judging by this criteria changes the UK leaderboard significantly.
Here are the top 10 UK dividend stocks on the FTSE 100 with dividend growth stretching back until at least the year 2000.
|Company||Years of consecutive dividend growth||Current Dividend Yield|
|Scottish Mortgage Investment Trust||21+||0.3%|
|British American Tobacco||21+||7.9%|
In the dividend race, be the tortoise, not the hare. Source: Dividenddata.co.uk, April 2021. Past performance is not a reliable indicator of future returns.
What you will notice is that a lot of the current dividends on offer aren’t all that impressive. Quite a few even sit below the current FTSE 100 dividend yield of 3%.
So far it seems to be a choice between a decent yield and consistency, so how do you get access to both?
Well one way is to peer just beyond the nosebleed-inducing yields to the companies with slightly lower payouts who are more likely to actually pay it.
Look for the high yields, not the highest yields
Wellington Management dug into data from 1930-2020 and found that US stocks offering the highest level of dividend payouts have trailed behind firms paying high, but not the highest, dividend yields.
Wellington divided dividend-paying stocks into quintiles by their level of dividend pay outs. The first quintile consisted of the highest dividend payers, while the fifth quintile made up the lowest dividend payers.
High dividends might be a better option than ‘highest’ dividends.
A key reason why the second-string outperformed the headliners was because, quite often, the very highest yields ended up flying too close to the sun. They were more likely to be cut and, as a cohort, were less sustainable than the second tier.
As dividends recover from the bizarre year that was 2020, it might be even more prudent to look beyond the chart-toppers – we want rock’n’roll hall of famers, not one hit wonders.
And, as special dividends are thrown around and companies tentatively explore resuming payments, the landscape this year is likely to be a bit uneven for a while yet.
It might feel instinctive to make up for the dividend drought last year by jumping on the highest yielders now but history shows us that flame might just burn brilliantly and briefly.
Taking a step back and factoring in consistency, and a firm’s commitment to paying dividends, has never been more important. Hunting in the 4-7% range feels a bit more reasonable – it’s still above the FTSE’s average and isn’t quite getting to a level where firms might struggle to pay out.
Although we should say that yields are never guaranteed at any level. It’s important to diversify, so all your income isn’t reliant on just one stock.
Top investment trusts for dividend income
One way investors can take out both the legwork and the guesswork is to have a look at income-focused investment trusts. And the focus doesn’t come more pronounced than in the AIC’s dividend heroes.
These are trusts who pride themselves on keeping a long-lasting dividend record intact.
To be a UK dividend hero, a trust has to consistently increase its dividend for at least 20 years, with some going much further than that.
Some of them have even managed to raise their payouts for over 50 years. You’ll pay a management fee for that peace of mind so it’s important they live up to their goal and provide that value for money.
Not all heroes wear CAPEs.
These trusts don’t track an index, it’s up to the human manager at the helm to select the stocks they think hold the best opportunity for stable growth and income.
A real highlight of the trust structure, when we’re talking about dividends, is their ability to reserve up to 15% of their income in the good periods so they can top up payments to investors when dividend income suddenly becomes hard to find.
This means payments can be kept relatively stable – a huge plus for people who need a dependable level of income, like retirees.
Avoid dividend clumping
There’s an important point to make here. A lot of these trusts are in the UK equity income sector and that means they’ll share quite a few holdings.
If you hold a few similar trusts, under the surface the chances are you’re doubling or tripling up on the same companies.
Bizarrely, this can mean that while you think you’re diversifying, you’re actually concentrating your money on just a few companies.
Keep it simple, keep it diverse, and keep an eye on all of it.
ETFs for dividend income: know your ACC from your INC
If you prefer to invest in ETFs, there are a few handy options which bundle all the big dividend guns into one package.
Funds like the SPDR S&P US Dividend Aristocrats ETF, which tracks the 60 highest-yielding US stocks with 25 consecutive years of growing dividends, and the SPDR S&P UK Dividend Aristocrats ETF, which follows the performance of the best UK dividend stocks, are there to do the job for you.
But even if you opt for a broad index ETF with a view to racking up market-matching dividends over the long-term, make sure you’ve got the right share class.
If you’ve picked up a ‘distributing’ or ‘INC’ version (you’ll see that information at the very end of the fund’s name), any income you receive will land in your account as cash. That might suit you if you want to withdraw and use that money.
If you want it automatically reinvested back into the ETF, go for the ‘ACC’ class so your dividends accumulate and generate compound interest of their own over time.
The last thing you want is to leave your account to gather dividends over time, only to realise later they’ve just ended up in a cash pile rather than being put to work in the stock market.
Discrete calender year performance
Past performance is not a reliable indicator of future returns.
Source: FE, as at 29 Apr 2021. Basis: bid-bid in local currency terms with income reinvested.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change.
This article has been provided by Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).