The shares the pros are backing to deliver their high yields

Income investors attracted to high-yielding shares have had quite the time of it this year bolstered by chunky dividend payouts and share buybacks across many UK sectors.

This is translating into some healthy gains. For example, the Morningstar UK Dividend Yield Focus Index – which tracks the performance of high-quality, UK dividend paying stocks – was up 10% in the second quarter of 2024 compared to 12 months previously.

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Jacob Reynolds, asset management director at Courtiers Asset Management, notes: “If you look outside big tech in the US, which dominates all the storylines, you can find value everywhere. You are going to find massive dividend payers and big fat dividend yields because shares are so cheap. Some of the yields we are seeing are astonishing.”

High yield, of course, isn’t a panacea for investors. According to Richard Hunter, head of markets at interactive investor, the dividend yield often does not tell a stock’s full story.

“Dividend yield is calculated as the amount of the dividend divided by the share price, expressed as a percentage,” he explains. “This is important because, all things being equal, if a share price falls, the dividend yield will rise. A seemingly healthy dividend yield could, therefore, be the result of a falling share price. At the other side of the coin, it could be a company potentially in trouble.”

The key, therefore, is to find a high-yielding stock with reliable and sustainable dividend growth. We asked income professionals which high-yielding shares or funds they are backing – above 5% – and why they believe the dividend is safe.

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Guido Dacie-Lombardo, manager of the Montanaro UK Income fund, which invests especially in high-quality, growing small and mid-cap companies that pay a reliable dividend, says REITs are a particular high-yield focus at present. “We consider it to be an attractive and high-yielding sector, but it is important to remain selective,” he says.

Specifically, he favours companies benefiting from a mismatch in supply and demand, such as the logistics or self-storage sub-sectors. He adds: “This mismatch enables businesses to deliver high occupancy rates and good pricing power, which in turn provide a structural underpin to growth, revenue visibility and, ultimately, dividends.”

He mentions LondonMetric Property (LSE:LMP), a specialist in logistics warehouses close to urban centres, which boasts greater than 99% occupancy rates, excellent pricing power with 79% of assets having contractual embedded price increases and sticky customers as a good example. “The business has an unbroken dividend track record since it was formed in 2013,” he states.

Dacie-Lombardo also picks out Big Yellow Group (LSE:BYG), a leading self-storage player, which has a 15-year track record without a dividend cut. “Overall, we would expect reducing interest rates to be supportive for valuations in the REITs sector," he adds.

Reynolds picks out UK high-yielding shares Persimmon (LSE:PSN), Marks & Spencer Group (LSE:MKS), Lloyds Banking Group (LSE:LLOY) and Legal & General Group (LSE:LGEN). 

He notes: “Being a dividend payer is really important as it shows the stock is cash generative, respects shareholders, has stability and is also a good sign of corporate governance. Dividend yield is one of the value metrics that we use.”

Reynolds notes that Legal & General and Lloyds, with forecast yields of 9.4% and 5.1% (as at 27 August 2024) are both expected to see their yields increase given huge share buyback programmes. He adds: “This could leave both yields in double figures.”

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Indeed, Lloyds has a £2 billion share buyback programme, with Legal & General planning a £200 million buyback programme this year and more planned until 2027.

Clive Beagles, co-manager of the JOHCM UK Equity Income fund, which has an emphasis on higher-yielding stocks, also advocates for financials. The fund has Aviva (LSE:AV.) in its top 10 holdings with a dividend yield of around 7%.

“People have worried about leverage in the life sector, but we still see nice growth in bulk purchase annuities and workplace pension businesses,” says Beagles. A third of its fund is in financials mainly in banks. Barclays (LSE:BARC), NatWest Group (LSE:NWG) and Standard Chartered (LSE:STAN) are in its top five holdings.

“Banks still look attractive,” says Beagles. “They have very low bad debt charges relative to history and certainly with the three main domestic UK banks are likely to see profits continue to go up. Standard Chartered’s management is also getting on with improving the quality of their business.”

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Beagles has also been adding real estate, particularly stocks focused on retail, in the last couple of months. “Out-of-town retail centres are beginning to see rental growth and quite healthy demand, so Hammerson (LSE:HMSO) will be a beneficiary of that and Land Securities Group (LSE:LAND),” he states. “Housebuilder stock prices have also performed strongly in the UK in anticipation of interest rates coming down and that activity will pick up. But anything ‘downstream’ of that such as carpets, sofas or brick manufacturers haven’t seen that pick-up yet. That looks like an opportunity to us in terms of finding healthy dividend yields.”

He also mentions broadcaster ITV (LSE:ITV), yielding around 6% and advertising group WPP (LSE:WPP) yielding over 5%.

Beagles says: “The underlying advertising trend is improving helped by the recent Euros tournament but also consumer goods firm looking at more product and brand development.

“Another opportunity are small-cap construction stocks such as Kier Group (LSE:KIE) and Galliford Try Holdings (LSE:GFRD) driven by infrastructure investment. The quality of these businesses is improving, they are on quite modest multiples and yielding 4 to 5%. These will grow nicely along with earnings.”

Ben Lofthouse, head of global equity income at Janus Henderson, says consumer staple stocks could also be of interest to investors. “We don’t own these stocks, but Diageo (LSE:DGE) and Reckitt Benckiser Group (LSE:RKT) are yielding more than they have for years. It is not 5%, but high 3% and 4%,” he says. “We see valuations becoming more attractive and believe they would benefit further from interest rates falling. However, you do have to be careful as to whether slowdowns in sectors such as consumer staples are structural or cyclical.”

Kamal Warraich, head of fund research at Canaccord, is certainly “conservative” when it comes to stocks yielding north of 5%. “There is a natural historical plateau leading to a higher chance of a dividend cut,” he says. “We like funds giving 4.5%-plus such as Artemis Income and Threadneedle UK Equity Income. Investment trusts such as Dunedin Income Growth Ord (LSE:DIG) Investment Trust are another way to get higher yields closer to 5%.”

Avoiding value traps is key when it comes to high-yield investing with Dacie-Lombardo stating that he will not chase yield at the expense of quality. “Our investment process starts by assessing a company’s quality and growth prospects. Only once we are satisfied that these are robust, do we consider valuation and yield. Indeed, we find that companies are often 'cheap' or high-yielding) for a reason – a lack of quality and growth,” he says.

Beagles adds: “Often some of our most successful investments are questioned at the point of purchase by those who think they are permanently damaged franchises. But in reality, they are at a cyclical low point, or the managers have mis-managed.”

There are some exceptions. “Telecoms have been high yielding for ages, but it has been a bottomless pit of CAPEX and limited pricing power. To us that is a hard yard’s sector,” he says.

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In addition, he advises investors to make sure companies aren’t distributing all their remaining free cash flow in dividends to support a share price. “It’s like a melting ice lolly, each time it tastes good, but it is smaller than it was the last time! We want companies re-investing in their business to grow,” he says.

Warraich also urges investors to look at cash-flow yield to avoid value traps and find companies with sustainable business models, low debt and good brand loyalty.

Dividend cover - effectively the number of times a company could pay a dividend to shareholders from current earnings - is also critical.

Assessing dividend sustainability is always important, but particularly so in the months ahead if UK interest rates continue to fall. Warraich notes: “Money will go back into higher-yielding equity assets when the base rate comes down. There will be more of a marginal hunt for yield potentially into areas such as utilities and infrastructure.”