Income Investing: watch out for dividend shocks & surprises

A high yield and a track record of paying or growing a dividend may entice income-seeking investors to invest in a company's shares. But their competitors may hold the key to whether that dividend can be sustained or grown.

That’s the premise of research from Deutsche Bank: companies cut or raise their dividends based on their level of confidence, not just in their own business, but the industry in which they operate.

Dividend attraction

With bond yields low after a long rally, many investors see dividend-yielding shares as a more sustainable source of income than fixed interest stocks, with some analysts predicting a ‘great rotation’ between the two asset classes.

Thankfully for those investors, UK companies are expected to increase their dividend payouts this year. Research firm Markit expects 76% of UK FTSE 350 companies to increase their payments in 2013, the highest level of increase in six years. These might not be ordinary dividends, where increases may only be modest. Instead they could include special payments or share buy-backs.

Share registrars Capita also expects higher dividend payouts in 2013, rising from £8.8 billion distributed last year to £8.9 billion.

Deutsche Bank has compared individual company dividend payouts and free cash flow (an indication of a company’s financial strength, and ability to pay a dividend) relative to those across the sector in which they operate. Based on analysis of data going back to the mid-90s, the German bank reckons if the company pays a low dividend compared to its sector, but has plenty of cash flow to cover the payments, it might raise its dividend, delivering a positive surprise to investors. Or vice versa.

The latest results for UK companies are shown in the tables below. On this basis, Unilever (ULVR.L), for example, could disappoint in 2013, while Tate & Lyle (TATE.L) could surprise investors.

Potential for upside dividend surprise: UK companies with low payout and high free cash flow cover relative to subsector (source Deutsche Bank)

Image description: Click to enlarge

Note: Rec = Deutsche Bank's recommendation on the shares

Risk of dividend disappointment: UK companies with high payout and low FCF cover relative to subsector (source: Deutsche Bank)

Image description: Click to enlarge

Note: Rec = Deutsche Bank's recommendation on the shares

Fund choices

The figures from Deutsche aren't meant to be taken in isolation, but could provide an aid to investors seeking out dividend-paying shares. 

Many investors, rather than picking individual shares, are prepared to pay a fund manager to do the job for them. The latest stats from the Investment Management Association show that UK equity income funds were the most popular in November (the latest month for which numbers are available) with net retail sales of £221 million – the highest since May 2007.

Citywire Selection, our pick of what we think are the best funds available, includes a large number of equity income funds.

Of these, we have two Star Picks.

The first is UK-focused, the Threadneedle UK Equity Income fund , run by Leigh Harrison and Richard Colwell.

The second is global: the Veritas Global Equity Income fund , run by Andy Healey and Charles Richardson.