It has been a dismal few years for income investors.

Dividend cuts from the banks and BP were just the tip of a very large iceberg: research by Capita Registrars found that more than 300 companies cut or passed their dividends in 2009 and 2010, which meant that total dividends last year were a painful 16 per cent below that of 2008.

The drop off has been bad news for the millions of investors in equity income funds, many of whom have also seen their payments slashed. Jonathan Barber, manager of Threadneedle UK Monthly Income, says that underestimates the real extent of the fall: adjusting for the rights issues and recapitalisations over the past two years – which means that dividends are being spread over a larger number of shares – he estimates that underlying pay-outs are down by as much as a third.

‘It is unprecedented,’ he says. He points out that, for most periods, income funds do better than those badged as growth, but that has reversed over the past few years. Figures from FE Trustnet show that, in 2010 and 2009, the average fund in the UK equity income sector returned 14.6 per cent and 22.9 per cent respectively, well behind the 17.5 per cent and 30.4 per cent achieved by the UK all companies sector – a rough proxy for growth funds. 

But there should be good news ahead: Capita predicts that payouts will rise 13.7 per cent this year. While that is skewed by the return to the dividend list of BP, which was forced to ditch its payment following last year’s Gulf of Mexico oil spill, Capita estimates that underlying growth, excluding BP and other one-offs, will still be a healthy 7.9 per cent.

Barber is also optimistic, expecting dividend growth of around 13 per cent this year, or 10 per cent after adjusting for the effect of BP’s return to the dividend list. And he points out that equity income funds have started to beat their growth-oriented rivals: so far this year, according to FE Trustnet, the average equity income fund has produced a 0.1 per cent return, which seems a bit less niggardly when compared with the 1.4 per cent fall in the average UK all companies fund.

Dividends have always been an important part of equity returns: research by Brian Dennehy, managing director of financial advisers Dennehy Weller, found that in 85 per cent of all the 10-year periods since 1990, an investment in high-yielding shares would have done better than the stock market as a whole. 

The logic is easy to understand: while equities in general and individual shares can fall in and out of favour, dividends are – at least in normal conditions – predictable. If you expect stock market returns to average 7 per cent, locking in a yield of 3.5 per cent means you are already half way there.

But it is not just yield in itself that counts: dividend growth is also a crucial factor for the return on investments. Research by BlackRock found that, of the 11.8 per cent average annual return on investments over the past 30 years, 7 per cent was driven by dividend growth, 4.3 per cent by the yield on shares and 0.5 per cent or less from a change in the price/earnings multiple. That does not apply just in Britain, but consistently across all global markets. And the signs are that yield is especially important when market conditions are poor.

Ewan Cameron Watt, chief investment strategist of BlackRock Investment Institute, says: ‘A focus on high-yielding equities can play an important part in investors’ portfolios during market downturns. During the so-called “lost decade” of 2000-2009, when equity markets across the world fell, the cumulative return for the MSCI All Country World index stood at -12.35 per cent. When dividends were reinvested, the cumulative return stood at +9.26 per cent, demonstrating the value that dividends can deliver even during challenging market environments.’

For most income fund mangers, the ability of a company to grow its dividend is as important as its actual yield. Ian Kelly, manager of the Schroder ISF European Dividend Maximiser fund, says he is not interested in ‘cash cows with a 10 per cent yield, or companies which offer a high yield because they are under-investing in the business’. Instead, he looks at aspects such as the level of free cash flow, the normalised profit and capital expenditure levels in determining whether dividend increases are possible.

He says that it has become harder to find such opportunities over the past six months. ‘High-yielders have done quite well [recently],’ he says. 

He is ‘quite optimistic’ about the outlook for dividends, pointing out that the dividend yield on European equities is now above that on bonds (the first time that has happened since 1997), while companies have large amounts of cash on their balance sheets – close to €1 trillion (£900 billion) – which means that they should be able to afford to maintain payouts. 

Mark Barnett, manager of Perpetual Income and Growth Investment Trust, thinks that the situation in Europe – with Greece remaining on the brink of default – and uncertainty in the US, with the end of quantitative easing,  means that dividends will remain volatile.

‘But, on the bright side, equities are not expensive and some of the big dividend-paying sectors have performed quite well.’

He particularly highlights the telecoms, tobacco and, to some extent, pharmaceutical sectors as good examples of this. ‘The market has rotated back into these more reliable growth areas, away from the cyclical areas like miners and engineers. That is benefiting my portfolio.

‘They are defensive, not cyclical and they are very diversified – you are not just buying into one economy. They have also exhibited strong dividend growth over the last few years against a background of a more difficulty economy.’

Julian Chillingworth, chief investment officer of Rathbone Unit Trust Managers, thinks utilities offer good value, while Vodafone, on a historic yield of almost 5.5 per cent, is attractive. 

Phil Doel, manager of the F&C UK Equity Income fund, thinks that the giant companies – HSBC, Shell, BP and Vodafone – which are also among the more generous dividend payers, tend to perform best in ‘savage bear markets’. That’s one of the reasons they have struggled until recently. 

‘We are broadly positive about equities over the medium term,’ he adds. ‘But they could be soft for a few months yet on uncertainty about the US, Europe and the extent of China’s slowdown.’

That may mean investors will be cautious about piling into the market. But when they do – or if they drip feed money in – companies with decent dividend yields should be top of the shopping list. 

Dogs prove to be a yield-hunter's best friend

Money Observer’s own high-yield portfolio, the Dogs of the Footsie, has benefited from the renewed enthusiasm for defensive shares. Overall, the portfolio has gained 2.76 per cent, in share price terms, since it started at the beginning of February, rising to 5.13 per cent when dividends are included. See it online here.

That does not sound high, but it is a significant outperformance given the 4.35 per cent fall in the FTSE 100 index and 2.64 per cent drop in total return terms.  

The Dogs of the Footsie is made up of the 10 highest-yielding companies in the FTSE100, excluding those which have warned of dividend cuts; they are bought in equal proportions and held for a year. 

The performance of the current portfolio has been driven by a dramatic recovery of shares in utility company Scottish & Southern Energy, which have risen 15 per cent since February, and by GlaxoSmithKline, up 11.43 per cent, and 14.62 per cent in total return terms. 

That may mark the start of the long-awaited re-rating of shares in the pharmaceuticals sector, although rival AstraZeneca has yet to see the same benefit.  

Other stellar performers include property group British Land and United Utilities. 

Insurer Standard Life is propping up the bottom of the table with a 14.3 per cent fall, followed by rival Aviva, with a 6.9 per cent drop.

Investors can set up their own Dogs portfolio any time. Money Observer’s sister website Interactive Investor (www.iii.co.uk) offers a screening tool allowing users to rank shares on the basis of their yield, which can be used as a starting point. 

Remember, however, that the rule is to include all the top 10 yielding companies: do not exclude those which may look unattractive. Often, these can end up staging the best recovery.

2011 dogs make the running

Note: performance from 1 February to 16 June 2011. Source: Thomson Reuters

You can also visit the Dogs portfolio here.