Which shares for income?

Which shares for income?

The yield on BT of 19pc sounds good, but remember the adage "if it looks too good to be true, it probably is.

By Gavin Oldham
Last Updated: 6:47PM BST 10 Apr 2009

With the equity market close to a six-year low and with equity yields at historically high levels compared with gilts, the temptation is there for investors to switch into shares: not only in the hunt for income but also factoring in that one day the equity market will recover.

The challenge is, however, to find those rewards without shouldering too much risk; because whereas cash savings can face risk of default, it is in equities that you face investment risk.

Related Articles
Other inflation hedges
Is silver the new gold?
US fund manager declares war on UK trackers
Inflation: how to protect your portfolio
Deflation: How to protect your portfolio
Investors 'ready to return to stock market'

However, it is also worth remembering that since 1900 high-yielding shares have outperformed the stock market as a whole, 85pc of the time over 10-year periods. They've also outperformed the market since September 2008, when the markets really went into freefall.

As an example of the relationship between risk and yield, let's compare two blue chips with apparent dividend attractions: BP and BT.

This week, the yield on BT is 19pc net of basic-rate tax. Sounds good, but remember the adage "if it looks too good to be true, it probably is". Every analyst in the City expects BT to cut its dividend next time around. Investors should be cautious of above-average share yields: the market is telling you "the higher the yield the higher the risk".

BP has a yield of 9pc. Recently, there has been speculation that the low oil price may force the company to cut the dividend. This has proved unfounded, as BP's management has said the dividend will be maintained this year and it will try to maintain it into 2010, even if the oil price stays at current levels. So here we have some medium-term visibility and potential for capital growth if the oil price rises over the medium term.

When considering an investment for yield, note the dividend cover; this is how many times the profits cover the dividend and is an indicator of whether a company will be able to pay future dividends at the current rate or higher. It is calculated by dividing the net earnings per share by the net dividend per share.

For example, if a company has earnings per share of 5p and it pays out a dividend of 2.5p, the dividend cover will be 5/2.5 = 2. The higher the cover, the better the chance of maintaining the dividend if profits fall. However, a lower figure may be acceptable if the group's profits are relatively stable.

So a good portfolio of equity income shares would feature mainstream companies with good dividend cover and a relatively recession-proof business (such as energy), plus a good helping of the FTSE 100 iShare – a form of exchange traded fund (ETF) marketed by Barclays – to provide some extra diversification, and to provide the opportunity to take advantage of market volatility.

Such a portfolio might include BP, yielding 9pc with 2.6 times dividend cover; GlaxoSmithKline, yielding 5.5pc with 1.6 times cover; National Grid, yielding 6.5pc with 2 times cover; Scottish & Southern, yielding 5.7pc (1.7); Shell, yielding 4.2pc (3.5); Vodafone, yielding 6pc (1.8) plus the FTSE iShare yielding 5.1pc with no cover calculation available.

An investment of £12,000 could therefore give you about £710 income over a full year, an overall yield of 5.9pc.

These equity shares could provide a relatively stable source of income combined with the potential for capital growth. There is, of course, a risk of further setbacks in the markets that could take your investment value lower, but with blue-chip companies like these it's a relatively low-risk portfolio as equities go.

Keep in touch with the companies you've invested in: if you hold the shares in an Isa or a broker's nominee, opt in for shareholder communications direct from the company. It's your right to be kept informed and it shouldn't cost you extra.

Your holding in the FTSE 100 iShare may provide the opportunity to do some tactical purchases or sales. Rather than buying the whole holding at once, you could invest in £1,000 steps as the market falls back, then set a limit at, say, 10pc up on your purchase price to sell as the market strengthens.

This way you can take advantage of short-term volatility to improve the return on the portfolio as a whole. Finally, if you're a taxpayer make sure you use your Isa allowance to minimise your income tax bill.

Gavin Oldham is chief executive of the Share Centre

http://www.telegraph.co.uk/finance/personalfinance/investing/5131421/Which-shares-for-income.html