Should you opt for higher income today or tomorrow?

Bumper dividends could be on the way, but investors should beware broken promises, according to a report by AJ Bell.

Nine firms are forecast to offer a yield of more than 7% in 2021. Rio Tinto tops the table with a forecast dividend yield of 12%. BHP Group is next at 9.2% and Imperial Brands third at 8.7%.

The report, which was issued last week, stated that investors would need to look carefully at the list of the highest-yielding firms. “Just ten companies are expected to generate 87% of 2021’s dividend increase,” it said. “With Rio Tinto and BHP Biliton in the top two, income-seekers will need to keep an eye on the price of iron ore in particular.”

“Often, defending a high yield can be a burden for a firm as it sucks cash away from vital investment in the underlying business or can be a sign that the company is in trouble,” the report continued.

“The strongest long-term performance often comes from those firms that have the best long-term dividend growth record, as they provide the dream combination of higher dividends and a higher share price.”

Look forwards, no backwards

Baillie Gifford says that “For too long, investors have had to hold their noses and buy troubled companies with high dividend yields if they want an income. In 2020 this paradigm was exposed as fatally flawed.

“The growth approach to income asks investors to look forwards, not backwards. It advocates embracing companies with bright futures – companies that are reinvesting appropriately in their business and paying lower but sustainable dividends. Our belief is that this approach to income will continue to bear fruit for many years to come.”

Best of both worlds?

But many income investors need a certain level of yield to help pay the bills. So can investors get the best of both words? Alan Dobbie, co-manager of Rathbone Income, told us: “We are often asked whether we prefer to invest in companies with high dividend yields but modest growth prospects or those sporting a lower starting yield but with greater growth potential. Our answer is always that it depends on the opportunity – valuation, liquidity and context are key.

“We aim to understand the sustainability of a company’s free cashflow and management’s capital allocation framework i.e. whether they use their ‘excess’ cashflows to invest for future growth (organic or via M&A), pay down debt or return it to shareholders (via buyback or dividend). Each of these options has its own risks and rewards, and it is management’s job (and ours) to understand these payoffs.

“The energy sector provides an intriguing example of this process in action. The oil majors generate prodigious cashflows but their sustainability is in question. As a result, Royal Dutch Shell and BP have embarked on ambitious transformations. Dividends have been slashed to free up cash to invest in renewable energies. Will renewable returns be sustainably high enough to offset fading hydrocarbon cashflows? Will the market continue to view these companies as part of the problem rather than part of the solution? While the stakes are high and the risks meaningful, in time, we believe these former high yielders could become solid dividend-growers.”

Job Curtis, manager of City of London Investment Trust, added: “In portfolio management, avoiding mistakes is just as important as investing in the winners. So you have to be a bit careful if something’s on a suspiciously high yield. But at the same time, there could be positive reasons, which mean it could be an opportunity for an income fund, which growth investors might be shunning. You’ve got to keep an open mind.

Diversification is everything

By investing in a portfolio of many different dividend-paying companies, all-important diversification can be achieved. And, at the same time, it is possible to create a portfolio that can yield more than the market without necessarily increasing risk. Nick Clay, manager of TM RWC Global Equity Income fund, told is more in this podcast:

Another equity income investment trust that combines stocks with different income characteristics is Schroder Income Growth Fund. Manager Sue Noffke said: “Looking at the portfolio today, overall, we estimate that just under half of the portfolio continues to grow dividends over the longer term. This component comprises three elements – companies yielding broadly in line with the market, companies yielding less than the market, but growing faster, and companies yielding in excess of the market and growing faster, in the ratio of 3:2:1 respectively.

“Around one third of the portfolio has broadly stable dividends. This bucket is split not quite equally, between those lower yielding companies with stable dividends which are funding growth opportunities, and a slightly bigger bucket of companies with more mature businesses which have stable to low growth dividends, but higher yields.

“The balance of the portfolio, 15-20%, has seen dividends impacted by the Covid Pandemic. In normal circumstances we would expect these holdings to be growing their dividends from attractive base levels of income.”