The 6% club

There are some pretty impressive dividend yields in the FTSE100 index at the moment. Below I look at the stocks with yields above 6%. I've omitted the insurance companies Standard Life, RSA, Aviva and Resolution from my analysis as I tend to avoid these as their businesses are too complex for me understand and therefore invest in.

Man Group (EMG)

At the top of the list with a whopping 19.1% dividend is the hedge fund managers and futures brokers Man Group. Of course it's too good to be true. The dividend cover is 0.7 and has fallen from 44c a share in 2010 to 22c in 2011. Even normally overoptimistic analysts forecast a fall to less than 17c in 2013.

One of the directors also sold off a decent sized stake in June 2011 for over 240p a share although he has bought most of that back for between 175 and 185p a share, still well above today's price of less than 75.

For me this is clearly a falling knife. It's a complex industry sector, it's dividend is unsustainable, future estimates for growth are negative and the share price is in a strong downtrend.

BAE Systems (BA.)

Second on the list with a 6.9% dividend is weapons maker BAE Systems. The dividend cover is well over 2 and forecasts going forward look positive.

There was a lot of director activity in March as options were exercised. The result was a net selling by the directors which would make me slightly wary.

Let's see what the figures give us. Using the valuation method I outlined in my post "Selecting and valuing individual stocks" gives a 3 year average dividend yield of 6.3%. The annualised analysts growth rate of 3.3% a year for the next 2 years we will discount by 60% to 1.3% a year as a margin of safety. As the shares are yielding over 5.5% at present this would suggest they are undervalued. If we discount this over 20 years we get a positive adjustment rate of 0.7% a year.

Therefore our annual expected rate of return will be 6.3% + 1.3% + 0.7% = 8.3%. Quite an attractive return.

Any negatives? Well the share price has just broken its 100 day low which could indicate a downtrend forming:

  

The net selling of the directors earlier is also an area for concern and some investors may have ethical reasons for not wanting to invest in a weapons maker (which could also explain some of the value in this stock). The returns look good but it could be a case of wait and see.

AstraZenica (AZN)

Next comes the pharmaceutical giant AstraZenica. Personally I like this sector. The dividend is currently an impressive 6.8% with cover greater than 2. Analysts have mildly positive expectations on the dividend growing by an average of 1.9% a year over the next 2 years.

How do the numbers stack up? The 3 year average dividend yield is 6.2%. Our adjusted growth rate will be 0.8% (40% of 1.9%). Again as the dividend yield is above 5.5% we will adjust to compensate for the undervaluation of the stock by +0.6% a year. This gives a total expected return of 7.6% pa.

Unfortunately AstraZenica is on a downtrend. 

This could be a very good investment but at present its another case of wait and see.

ICAP (IAP)

Broker ICAP with a 6.4% dividend comes next. The dividend is covered at just under 2 times and has a good track record of consistently increasing its dividend. Analysts have a cautious growth rate of 3.1% per year over the next 2 years.

The figures give us a 5.8% 3 year dividend yield. A growth rate of 1.2% and an adjustment factor of +0.3%, giving a total of 7.3% pa.

ICAP is on a long term downtrend as you can see in the chart below:

In addition to this there has been some director selling of the stock. Personally I'd avoid for now.

Scottish and Southern Energy (SSE)

Finally we have Scottish and Southern Energy. A fairly simple utilities business with a current dividend yield of 5.9%. The dividend cover of 1.4 is fine for a fairly predictable business like this. The dividend has been steadily rising and analysts forecast an average annual growth in dividend of 4.5% a year.

Those figures give a 3 year dividend yield of 5.5%, a growth rate of 1.8%, and no adjustment is needed as we have a 5.5% dividend already. Total return therefore of 7.3%.

The price action looks strong and in March and April 100 day highs were broken.

There was some director selling last June at prices similar to today's level. The total sell off by the directors was over £200,000 but as these same directors still own over £5m of stock it doesn't concern me a great deal.  

Of the above 5 stocks I would feel safest investing in SSE. It's a simple business model and the stock is showing good price action and consistent dividend growth.