(By David Brickell) With third quarter dividend payouts reaching their highest ever level, it is clear that income stocks are continuing to prove alluring to yield hungry investors. But while overall dividends grew for the seventh successive quarter between July and September, the level of growth dropped markedly. While it might be too early to predict any kind of significant dividend pullback, it is worth keeping an eye on which stocks are delivering the best forecast yields. Dividend strategies have easily outstripped the FTSE so far this year – and forecasts indicate that the country's biggest insurance companies are where the highest yields will be.
How do you find these stocks?
Among our income stocks screens at Stockopedia, arguably the best known are based on the formula set out by US fund professional Michael O'Higgins in his book Dogs of the Dow. We have discussed the principles behind the UK equivalent strategy at length here (and in our dividend book – How to Make Money in Dividend Stocks – here) but essentially Dividend Dogs of the FTSE is about buying the highest yielding shares in the FTSE 100 and holding them. The regular Dogs screen, which uses historic yields, has turned in a respectable year-to-date performance of 15.5%. However, its less well known younger brother, the Forecast Dogs of the FTSE, which uses the one-year rolling dividend yield made up of a weighting of the next two years' dividend forecasts, is beating that with a blistering return of 21.7%.
It's a balancing act…
It is important to note why Stockopedia's Dogs of the FTSE screens have performed so well in 2012. By comparison, the same screen (the regular Dogs of the FTSE) tracked by Money Observer has produced a negative return so far this year. The reason is that our portfolio has been rebalanced quarterly whereas Money Observer's has not. Now, O'Higgin's original strategy was to buy and hold the stocks for 12 months, which is what Money Observer have done. Even then, critics of the strategy have claimed that it can incur some hefty fees when carrying out the annual rebalancing. By rebalancing quarterly, we have racked up even more trading costs. Broadly speaking, those fees would involve 2% (stamp duty) + 1% (spread) + £400 (commission), which undoubtedly puts a dent in the return. As it turns out, the strategy's success has more than made up for those costs – so far, at least.
…and it doesn't always work
For investors guided by yield, it is worth making the point that research suggests that the 2nd and 3rd decile of yield are a safer and more reliable place to be. High yields can be red flags for possible trouble ahead so combining relatively high yields with good quality companies could be an alternative approach.
Insurers top the table
Turning to the current crop of stocks that have propelled the performance of the Forecast Dogs of the FTSE screen, the leading four companies on a one-year rolling yield basis are insurance groups. Topping the list with a rolling yield of 8.94% and dividend cover of 1.25 is Resolution (LON:RSL), the acquisitive investment vehicle launched by Clive Cowdery in 2009. Resolution has been something of an enigma for investors because of its twin-headed approach. This involved an acquisition and strategy unit based in Guernsey and its so-called UK Life Project (Friends Life Group), which was a merger of the UK operations of Friends Provident, Bupa and AXA UK. Plans to split the group have now been dropped and the focus is on streamlining governance and delivering shareholder value, which has earned it more favourable reviews from brokers.
Next in the list is one of Britain's biggest insurers RSA Insurance (LON:RSA), which said this month that it was making progress despite economic and market uncertainty. In February, as a result of subdued growth in some markets, RSA revised its dividend policy with a plan to grow its payouts at low single digit rates while the current economic conditions persist. Nevertheless, with a rolling yield of 8.47% and dividend cover of 1.41 it remains one of the best performing yield stocks on the Forecast Dogs of the FTSE screen.
One of the key strategies at RSA has been to reduce its exposure to the cyclical UK Motor insurance sector, where premiums have been falling this year. At rival group Admiral (LON:ADM), which is heavily reliant on car insurance business, strong growth resulted in a record interim dividend this year. That pushed the rolling yield to 8.14% with the lowest lever of cover among to top-four stocks at just 1.07. The latest news from Admiral is that third quarter revenues fell slightly, with the car insurance business trading broadly flat on last year. The figures triggered some downbeat broker analysis, which contributed to a sharp fall and equally quick rebound in the stock price as directors bought shares.
Finally, in fourth place in the Forecast Dogs of the FTSE screen is Aviva (LON:AV.), whose growth and valuation indicators on the Stockopedia stock report are all in positive territory. It also boasts a rolling yield of 7.61% and cover of 2.07. Aviva's figures – including last year's dividend cover of 0.65 – mask some big strategy changes that are under way. The company is selling several major business units in order to focus on the UK and a few other core markets in Europe and North America. Following the departure of Andrew Moss as CEO in a pay and performance dispute in May, the search for a new chief executive continues.
Be wary of high yield
Given the overall strong growth of dividends so far this year it is perhaps unsurprising that the Forecast Dogs of the FTSE strategy has outperformed the market – in spite of the high costs of running it. While the screen has performed well, it is worth remembering that broker forecasts can often be wrong, which is an extra layer of risk in this strategy. For investors chasing yield over the long term it could be more effective to use a strategy with a broader safety net that delves deeper into the quality of a business rather than simply tracking size and yield. Either way, while predictions over dividend growth next year may be less certain, it looks likely that income stocks will remain a major source of interest for investors going into 2013.
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