Can you beat 5 per cent with UK dividend shares?

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One of the problems with being a fund manager is taxi drivers giving you fund tips and friends asking for them.

I have been asked a couple of times recently for shares that will deliver a reliable 5 per cent annual return. I know why. The Bank of England base rate has started edging down; the Fed is now following suit. Rates on cash accounts, currently delivering a “risk-free” real return, are going in the same direction. Is it time to buy some stalwart UK dividend-paying stocks to lock in higher returns — albeit for more risk?

There is logic to the idea. And I can think of some companies I like that currently pay more than 5 per cent, though I would be a poor friend if I did not also give some caveats.

It is easy nowadays to screen the FTSE 100 for high-yielding stocks. Be cautious about the dividend yields you see on investment platforms. Are they historical yields or based on forecast earnings? And where will the yield be in three years?

Before investing, scour the company cash flow statements. It is here that you will see how much profit is available after everyone has been paid. These will give you a breakdown of sales, revenue and profits. They show the size and cost of debt, adjustments and other useful financial statistics.

If you go on to the Tesco investors’ website, for instance, you can download a spreadsheet with the data over five years so you can see the trends. This includes extra detail such as the weekly revenue per square foot of store — £21.31, in case you are interested.

With all these numbers, you can work out the dividend cover to ensure the company is not paying out more than it can afford. This may sound a daft thing to do, but companies with a reputation for paying out high dividends are very cautious about reducing them in case they send shareholders scurrying for the exit gates and the share price plummeting. This is normally storing up trouble for later and explains why very high yields are often seen as a signal of a business on the wobble.

In truth, I think the sweet spot for income stocks is most likely to be found in companies paying 3 per cent to 5 per cent and growing their dividends. The growth is important. It compounds to protect your returns from inflation and growing companies can give you capital growth as well as income.

Sometimes the dividend is enhanced by share buybacks. Some estimates suggest as many as half of the UK’s listed firms bought back shares last year. I have mixed views on this, but with UK valuations so low, buybacks can be a powerful and flexible way of distributing surplus capital.

With UK valuations so low, buybacks can be a powerful and flexible way of distributing surplus capital

Investors need to factor in the effect of this. Tesco currently pays 3.3 per cent but it has reduced its share count by 15 per cent in three years and continues to buy more. Rival Sainsbury’s, paying a dividend yield of 4.4 per cent, has committed to a £200mn buyback programme this financial year. Factoring in these buybacks would lift the distribution yield of both firms beyond our 5 per cent watermark.

But my friend wants a simpler way to understand dividends. So here are some companies yielding more than 5 per cent which we are happy to own.

Insurance company Sabre yields 7 per cent. The business underwrites non-standard motor insurance — it is the place you go to if you are having a midlife crisis and have just bought yourself a 750cc motorbike. Most motor underwriters make very little on each transaction beyond the interest they get on holding the premium cash. But Sabre is doing well and has a good management team. 

BT yields just over 5 per cent. This is a recovery story, which means that when I start talking about it, people often groan, as they did when I suggested Rolls-Royce a couple of years ago. Allison Kirkby took the reins as chief executive in January and appears to recognise the importance of free cash generation. The business aims to cut four in 10 of its workforce by the end of the decade — that is 55,000 jobs.

Further down the line there is the possibility of the sale of a stake in Openreach, the clear market leader in building and maintaining the UK broadband network. We are seeing the share price pick up — over 26 per cent in the past year, but still on a modest price/earnings ratio of around eight times.

M&G is two years into a cost-cutting overhaul. It has had a rough time and that helps explain its 9 per cent yield. It has been a big ship to turn, but I believe it is heading in the right direction. It needs strong, consistent inflows to trigger a re-rating but falling interest rates, prompting my friend to ask about shares, are just what is needed to trigger a change of risk appetite that should benefit the big established asset gatherers. I believe we are being paid a healthy risk premium to hold this share.

Finally, Land Securities. Commercial property may not seem attractive at the moment but here you get a balanced portfolio of giant shopping centres, mixed-use city and town centre properties and high-quality central London offices at a discount of about 20 per cent, yielding 6 per cent. It is on a different cycle to the other stocks — one that we believe should benefit from longer-term recovery.

For all these reasons I continue to believe the UK is a good place to invest today. These shares might not satisfy a thrill-seeking London taxi driver, but together they look well placed to meet the needs of long-term, patient income-seekers.  

James Henderson is co-manager of the Henderson Opportunities Trust, Lowland and Law Debenture