The Income Investor: two FTSE 350 ‘super yielders’

The FTSE 350’s recent rise means that it now yields just 3.6%. This is substantially below the 10-year gilt yield of 4.3%, while savers can currently obtain an interest rate in excess of 5%. This may lead some investors to dismiss the stock market when seeking to generate a worthwhile income.

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However, a surprisingly large number of FTSE 350-listed companies offer significantly higher yields than the index. In some cases, these “super yielders” have a historical yield which is more than double that of the wider index. Clearly, such high yields are likely to prompt interest among income-seeking investors. But are they too good to be true?

The prevalence of high yields

Extremely high dividend yields are, of course, not a new phenomenon. There are nearly always outliers in the FTSE 350 that have historical yields vastly higher than that of the index. Given that dividend yield is a function of a company’s shareholder payouts and its share price, stocks that offer a high income return generally fall into two groups.

The first is where their share price is relatively cheap. This can be due to a whole host of reasons, including an uncertain financial outlook which causes investors to become more bearish about the firm’s value. This is then reflected in a lower share price that prompts a higher dividend yield. Income investors should seek to determine specifically why a company’s shares are cheap relative to the wider index. Doing so can mean they unearth risks or threats that dissuade them from investing.

The second is where a company’s dividends are relatively high. For example, a company may pay all of its profits as a dividend. It may even make shareholder payouts that are in excess of profits due to a dividend policy which is based on distributing a percentage of net assets or on returning surplus capital to investors in order to meet a specific leverage target.

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Some firms may even borrow money to enable them to pay a more generous dividend. Ultimately, though, dividends must be paid for by profits. Investors should, therefore, be cautious when a company’s dividend payout ratio (which is calculated by dividing dividends by net profits) exceeds 100%. In such a scenario, shareholder payouts are likely to prove unsustainable.

Yield (%)

Source: Refinitiv as at 5 June 2024. Bond yields are distribution yields of selected Royal London active bond funds (as at 30 April 2024), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 3 June. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (3 June). *Data prior to May is based on 3-month GBP LIBOR. Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 5 June.

Areas of importance

Of course, some “super yielders” may offer a favourable risk/reward opportunity. Downbeat investor sentiment that causes a cheap share price which, in turn, contributes to a high yield can be misplaced. For example, a defensive industry may not be en vogue among investors during a period of rapid economic growth. Meanwhile, mature firms that do not require a large proportion of profits to be reinvested in growth opportunities can pay a relatively high percentage of earnings as dividends, thereby providing a generous yield. They should not, therefore, be avoided simply because of a high dividend payout ratio.

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Moreover, income investors should not solely focus on yield when determining which stocks to purchase. Dividend growth is equally, if not more, important than yield because it can have a vast impact on an individual’s standard of living over the long run. Indeed, an investor who fails to obtain income growth which at least matches inflation will experience a fall in their purchasing power. Therefore, assessing a company’s capacity to grow profits, such as by analysing its competitive advantage versus sector peers, to increase dividends forms a key part of determining whether it offers income investing appeal.

So, too, does judging the financial strength of a business. Companies with lower debts are typically less risky and less likely to be forced to cut dividends to repay debts. A solid balance sheet also means a firm is more likely to successfully overcome periods of weak economic growth without needing to temporarily reduce shareholder payouts.

Legal & General

Financial services firm Legal & General Group (LSE:LGEN) is an obvious example of a FTSE 350 “super yielder”. It currently has a dividend yield of 8.1%, which is more than twice the income return offered by the FTSE 350 index. Although the company raised dividends by 5% in its latest financial year, and plans to increase them by the same amount this year so they are covered just 1.1 times by prospective earnings, a key reason for the stock’s high yield is its extremely low market valuation.

It currently trades on a forward price/earnings (PE) ratio of just 10.7. This is in spite of it generating a capital gain of 9% since it was first tipped in this column during May last year. Alongside this, it has delivered an income return of roughly 9% over the same period so that its total return stands at around 18% in little over a year.

The company’s latest annual results highlight that its financial standing and competitive position remain sound, while it remains well placed to capitalise on a diverse range of growth opportunities. For example, upcoming interest rate cuts and an improving economic outlook are set to boost the performance of its investment management division. Meanwhile, its pension risk transfer segment continues to have a large addressable market even after producing record new business volumes in 2023.

Clearly, investor sentiment towards the company could remain weak in the short run. But its high yield, upbeat future prospects and sound fundamentals mean it remains a worthwhile income stock for the long run.

Dunelm

Shares in home furnishings retailer Dunelm Group (LSE:DNLM) also offer an exceptionally high income return at present. Their historical dividend yield of 7.4%, though, includes a special dividend of 40p per share. Excluding this, the stock’s yield stands at a rather more modest 3.8%. This is only slightly higher than the FTSE 350 index’s yield of 3.6%.

However, the company has paid a special dividend in each of the past four financial years. Clearly, special dividends are inherently more susceptible to fluctuation and even cancellation, since in Dunelm’s case they are dependent on the firm’s debt levels. But with the company’s operating environment set to improve, the prospect of a continuation of its special dividend is reasonably high.

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Indeed, wage growth has been ahead of inflation since April last year. And with the rate of price rises widely expected to meet the Bank of England’s 2% target over the short run, a looser monetary policy that boosts the economy’s growth rate is on the horizon. This should bolster Dunelm’s financial performance, with consumer spending on discretionary items likely to rise and price consciousness among its customers set to moderate.

In the meantime, the firm’s solid financial position, as evidenced by net interest cover of 32 in its latest financial year, highlights its capacity to overcome an uncertain trading environment. Its ordinary dividends were covered 1.8 times by net profits last year, which suggests they remain highly affordable. And with its shares trading on a PE ratio of 14.7, the company offers fair value for money that could equate to capital growth over the long run.

Certainly, retail stocks are relatively cyclical. This means that they are unlikely to offer the stability or consistency of dividend stocks in sectors where profits are more dependable. Furthermore, Dunelm’s special dividend means investors should not assume that it will generate a 7.4% income return. But with an improving operating outlook and solid fundamentals, its risk/reward opportunity is relatively attractive.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.