Written by Liam Flavelle on 2 November 2017
- The Bank of England yesterday raised interest rates for the first time in a decade.
- At the same time, the UK is on track in 2017 to post record dividend payments.
- UK companies have collectively increased dividend payments by 15% from the previous year.
- We show you a trading strategy that takes advantage of this trend.
2017 has been a great year for UK income investors, with dividend payments hitting an all time high in the second quarter of the year. According to Capita Asset Services, dividend payments of $45bn (£33.3bn) were reported between April and the end of June, up 15% from the previous year.
UK stocks have experienced a number of tailwinds this year - in addition to strong underlying growth and increased special dividend payouts, sterling's weakness has supercharged the profits (and dividends) of companies with overseas operations. Multinationals declaring payouts in foreign currencies have also benefited from the pound's drop.
Companies in the UK have traditionally delivered a higher percentage of their total returns through dividends when compared to US stocks, and now is no exception with the FTSE 100 benchmark of top UK shares yielding 3.7%, almost double the 1.9% yield you would get if you invested in the S&P 500.
Cashing In On The Trend
So is this a trend that we can exploit to our advantage, and if so how?
The first thing we can do is model the returns of a simple trading strategy to see how long this trend has been going on for. We have used the InvestorsEdge.net platform to simulate the following returns:
You can see more statistics and backing information, including historical risk and position data and versions simulating currency effects, by clicking on any of the charts in this article or by clicking here (click on the History option on the left hand menu to see the different versions of the model).
What the above chart is telling us is that since 1st January 2000 a simple dividend strategy would have given you 11% annual total returns, compared to the FTSE 100's 3%. What's really interesting is the dramatic change from 2009 onward, which becomes more obvious when you look at the annual return chart:
What this shows is that our strategy muddled along for the first 9 years of the century, and then once the great financial crisis had passed became very profitable. As for why, we believe that the global central banks policy of low interest rates has forced income investors to search for further for yield and the UK, with its higher relative yields, has been a beneficiary of this movement of funds.
If we simulate the trading of our strategy from 1st January 2010 we get the following returns:
Our strategy is pretty straightforward and consists of the following steps:
Each quarter we screen all UK common stocks and depository receipts that meet the following criteria:
- Market Cap greater than GBP 250.
- Trailing Yield > 4%.
- Annual Dividend TTM Growth Rate over last 4 quarters > 7.5%
Once we have our list of stocks, rank (sort) them on the following factors:
- Payout Ratio (lower is best)
- Market Cap (lower is best)
Then buy or hold the top 10 ranked stocks in the list for 3 months and repeat. Our above simulations are based on investing GBP 10,000 at the start of the study - investing GBP 100,000 over the same 7 year period shows annual returns of 22%.
All investing carries risks and systemic investing, where you are trading a statistical anomaly, introduces a few more unique potential pitfalls.
Interest Rate increases are possibly the biggest threat to income seekers as many have invested in higher risk yield-producing assets to meet their needs, and rising interest rates will introduce headwinds that will impact total returns. While no one can argue that interest rates will rise in the future, especially with the Bank of England raising interest rates for the first time in a decade yesterday and the Fed having increased theirs four times since 2015, we believe that the pace of rate increases will be slow and income seekers will still need to reach for higher yielding, higher risk assets to meet their needs.
Diversification is an issue that regularly comes up when investing in UK stocks, where in 2016 the largest 10 shares paid out over 55% of all dividends. Our strategy would have invested 25% of its equity in financial stocks, a level that may not fit the risk profiles of some investors.
Brexit is another key risk to UK stocks for the next few years. The one thing that will cause investors to shy away from a particular sector, country or investment theme is uncertainty, which so far has been the major outcome of the various meetings between the UK and EU. Most forecasters are assuming the UK will experience subdued growth for the next few years until trade agreements have been agreed, which could obviously affect dividend payments. We believe that while the risk is serious, it could be at least partially offset by a corresponding drop in the value of sterling. Also, even though the same uncertainties have been present in the last 12 months UK companies have still exhibited strong growth.
Our last key risk is that the statistical anomaly our strategy utilizes simply stops working. This risk tends to increase with the complexity of your model, so the simplicity of our concept (buying the highest yielding companies with the safest payout ratios that are growing their dividends) reduces the risk of this strategy suddenly losing money. The key metric we watch with regard to dividend strategies is interest rates - we believe that this strategy will continue to outperform all the time investors are incentivized to reach for yield to meet their income requirements.
We see the UK as a hunting ground for quality, income-producing stocks where even a simple dividend-focused trading strategy has historically returned significant profits over the last 7 years. Whilst there are some headwinds on the horizon, we believe that these returns will continue until global interest rate policies change.