Alex Brummer

Despite BP, high yields are still worth chasing

Alex Brummer says blue chip stocks that pay a handsome stream of dividends are — usually — a reliable bet

Despite BP, high yields are still worth chasing
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Alex Brummer says blue chip stocks that pay a handsome stream of dividends are — usually — a reliable bet

First, I have a serious confession to make. For as long as I can remember, my informal advice to any UK investor considering a share purchase — particularly during the volatile years of the ‘great panic’ followed by the ‘great recession’ — has been to buy BP.

In a world ever more desperate for energy, the oil price had only one direction to travel over the long haul and that is upwards. BP looked particularly well placed to benefit because of its exposure (around 40 per cent of its income) to the United States and its uncanny knack for making discoveries in safe political neighbourhoods from the Gulf of Mexico to Alaska. Unlike its main European rival Shell (with its heavy exposure to Nigeria) it also paid a handsome dividend. Indeed, before the Deepwater Horizon disaster, it was contributing £1 out of every £7 of income received by the nation’s pension funds and savings institutions. In lists of high-yielding shares — that is, those paying the most dividend — BP had long been top of the league.

Despite BP’s modern record of safety disasters from pipe leakages in the pristine wilderness of Prudhoe Bay in Alaska to the deadly Texas City disaster of 2005, one assumed that the high yield, at around 7 per cent before the Gulf spill, was the result of huge cash generation and a healthy balance sheet. How wrong you can be. High yields, especially in the lower reaches of the FTSE 250, are as likely to be a light flashing red for danger as to be an investment come-on.

In the case of BP, although in truth no one could have been expected to recognise it, the yield almost certainly included a risk premium. Despite all the proclamations made by chief executive Tony Hayward that it was going to be safety first when he took over from fast-expanding and heavily cost-cutting Lord Browne, it looks to have been the same old BP: the income-to-risk dial was set in the wrong place.

The price being paid by BP share- holders is heavy. The dividend for the first three quarters of 2010 has been axed. Capital investment, designed to ensure future growth, is being trimmed and $10 billion of divestments speeded up. A tempting yield vanished along with much of the company’s value as it was caught in the political floodlights.

It would be a pity, however, if the BP affair, which has proved disastrous for all of us who hold shares, was allowed to warn investors off holding high-yielding stocks.

The age of fiscal austerity engineered by the coalition government almost certainly means that the current period of low official interest rates could endure at least until the end of the year. An easy-money policy will be the counterpoint to a sharp shrinkage in the public sector, plus higher taxes. Bank deposit rates will remain almost non-existent and gilt and bond yields low — unless investors want to take a chance on the ClubMed countries of Europe’s southern tier.

This brings us back to equities. In the world of investment guru Warren Buffett, all investment is about capital gain — which is why his main company Berkshire Hathaway has only once paid a dividend in its history. He runs, in effect, a mutual fund aimed at long-term investors thinking about their retirement pots. Indeed, while British investors have always favoured dividend payouts, US investors tend to be more focused on earnings per share and capital growth.

But not all investors have the privilege of being able to sacrifice income for future capital gains. Many people in the UK on fixed incomes depend on interest or dividend flows to support their lifestyles. So a good choice, in this interest-constrained environment, can often be a blue chip, high-yielding stock.

Utilities, which operate in a highly regulated environment, more often than not offer a sensible middle ground. A tightly policed regime means opportunities for capital growth are severely limited. So the best way of rewarding investors is by paying a steady dividend. Among the highest yielding UK stocks is Scottish & Southern, one of the few British-owned power companies and distributors. Severn Trent heads the list of water utilities with its yield of 6.5 per cent. Prior to its recent fundraising, National Grid, which delivers the nation’s electricity and gas, was also among the high-yielders.

Good returns are to be found among some of the more defensive stocks. Tobacco companies struggle to find willing investors because of the ethical questions about what they do. But as a result BAT, the most internationally diverse of these firms, is up among the high-yielders at 5.4 per cent. Similarly, ‘big pharma’, distrusted because of its regulatory exposure, offers decent returns, with Astra Zeneca and GlaxoSmithKline both offering yields in excess of 5 per cent.

Other defensive FTSE high-yielders include consumer goods firms such as Unilever and Britvic. For investors looking for a little excitement in new markets as well as yields, telecoms stocks tend to be a good bet. Vodafone throws off piles of cash and offers investors a near 6 per cent yield and, unlike BT, it does not have a legacy pensions issue over which to raise the red flag. Cable & Wireless offers even more.

The credit crunch and subsequent bail-outs have made investors generally shy of financial stocks. Insurance companies have been avoided because of concerns about tightened capital requirements. This has catapulted such big and safe names as Standard Life and Legal & General into the high returning lists on the Footsie. Ironically, their own shares often provide a better income than some of the investment funds that they offer.

But as much as I am attracted by high yields — albeit mistakenly in the case of BP — one should never look at the dividend income in isolation. It is important to make sure that the dividend can easily be paid for by earnings. At bankers HSBC, for instance, the dividend cover is almost two times.

If shares are bought on the basis of dividend alone there is always the risk of a freeze or a cut. So investors must be alert to the underlying performance and risks attached to investment. Nevertheless, in these days of low interest-rate returns, the combination of a nice dividend with possible capital gains is irresistible — despite the generally poor performance of equities over the last decade.