- Be careful high yields aren’t a red flag.
- Stay true to your investing philosophy.
Our large-cap screens give a spread of ideas for a portfolio of UK-listed income shares. When judging the small-cap and Aim-listed results, however, the investment case can instead often be one based on contrarian value.
High dividend yields can be a sign of value or even a warning. If the shares have sold off for some good reason, the trailing yield (i.e., based on what was paid out over the last twelve months) can look high but there may be cause to expect the dividend will be cut. This dynamic can apply to companies of any size but especially careful consideration should be made before buying small-cap shares on the basis of their high dividend yield.
A couple of names jump out from our Aim income screen where the business has suffered recent misfortune. In cases such as these, investors should ask two questions. Firstly, if their primary investing motive is income, is there a likelihood pay-outs may be trimmed to help the companies get on track? Second, if there is an appetite to take the risk of investing in recovery stories, is there a chance the shares have been overly punished?
In the case of data-driven growth consultancy Next 15 (NFG) that income investors should be wary of rising debt and restructuring costs, but that value hunters may feel some good underlying performance by some divisions is being lost amidst the fall-out from the recent large contract loss. When it comes to a company like Churchill China (CCH), which supplies crockery to the hospitality industry, an unavoidable cyclical lull may have created the conditions for a contrarian value play. Although, given it fails our cash conversion test, any buy case on this basis should factor in the speed of a cash, as well as an accounting, profits recovery.
Technology companies have faced issues where they provide solutions and services for larger products. In the case of Nexteq (NXQ), which tops our Aim screen, many of its customers had been running down their inventories of products which require the electronic display solutions Nexteq supplies. This trend contributed to Nexteq issuing a profit warning over the summer. However, as Simon Thompson wrote last month, and a healthy cash conversion score on our screen suggests the same, there is free cash flow to underpin the dividend yield and there is value on offer.
Of course, for steady long-term income investors, the core of the equities portion of the portfolio should be blue-chip stocks that can be steady and reliable payers. It is also important to diversify (dividends are never 100 per cent certain) with government bonds.