Investors' focus should shift nearer a dividend strategy

The prospects for equity markets over the next 12 months continue to look good with stocks expected to rise on the back of fundamental earnings growth. However, with valuations no longer at depressed levels the importance of dividend yields as part of your investment returns should not be underestimated.

When I started out in investment management more than 22 years ago, the world of private client portfolio management was much more simple than the one we find ourselves in today.

It was generally accepted that portfolios should consist of a combination of cash and direct holdings in government bonds and UK shares, probably also using investment trusts for exposure to international markets. There was nearly always a significant UK bias and value was added mainly through stock selection. Your private client investment manager, or stockbroker as they were more commonly known, would double up as an analyst and spend a considerable amount of time researching individual companies.

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Today, the range of investments available to private clients has increased dramatically. In addition to cash, gilts and equities our portfolios are now likely to have exposure to international sovereign and corporate bonds, private equity, global real estate, commodities and hedge funds.

Portfolios are constructed with a keen eye on controlling risk through diversification and understanding the level of volatility and liquidity appropriate for each client. This inevitably leads to a move away from stock selection to a concentration on asset allocation.

However, I am pleased to say the old skills are not yet redundant. Head of global strategy for HSBC Private Bank, Fredrik Nerbrand has highlighted dividend yields as an important factor in investment planning going forward. In a low interest rate environment and with many investors still preferring a cautious approach to investment, a quality dividend strategy offers an appealing proposition.

Broad stock market investment has delivered extraordinary returns over the last 12 months as the global economy has moved out of recession and financial markets have begun to price in a return to normality. In March last year shares looked cheap on a number of longer term valuation measures and much of the return we have seen since has been as a result of a general market re-rating.

But the global economic recovery is still fragile and uncertainties remain. We therefore believe that going forward, the performance of stocks and shares will more likely be driven by the underlying strength of individual companies rather than a continued increase in equity market valuations.

Against such a backdrop, it is more important than ever to remember that dividend income is a key part of the total return equation and a focus on dividend expectations should enhance performance.

The most promising strategy is to combine appealing dividend yields with important quality criteria such as a solid balance sheet, strong cash flows, good earnings visibility and attractive valuations.

Interestingly, very high yields in isolation should often be avoided as they can be a sign of companies in financial distress. Analysis of returns over the past 25 years shows that companies paying above-average dividends have significantly outperformed those with the highest yields for exactly this reason.

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In addition to providing a good income stream, investment in such companies does not mean missing out on capital growth.

Since companies have been forced by the current economic climate to cut costs and run a lean ship, when business improves the impact is instantly seen on the bottom line and share prices should react accordingly.

In a recent survey commissioned by HSBC Private Bank, 67 per cent of Scotland's leading business owners saw the current economic climate as an opportunity for entrepreneurs. For listed companies, increasing profitability means greater potential for future dividend growth.

So when selecting stocks for such a dividend-focused strategy, high quality international blue chip companies with solid cash flows should be favoured. But significantly, the criteria can be applied across all sectors, so avoid the temptation to put all your eggs in one basket by focusing on one traditionally high yielding sector such as utilities or telecoms.

Diversification across asset classes, geographical regions and industries remains vital in order to manage your risk.

Joss Mitchell is director of HSBC Private Bank in Scotland

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