The Income Investor: FTSE 100 retains income appeal despite record rally

The FTSE 100’s surge to an all-time high may naturally prompt some income investors to question the appeal of large-cap shares. After all, the index’s rise means dividend yields will inevitably have been squeezed and market valuations will have expanded. This could equate to lower returns in future.

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However, the index’s new record needs to be put into context, with its performance having been hugely disappointing from a share price perspective (excluding dividends) for the past 25 years. While the S&P 500 index has gained 256% since the turn of the century, the FTSE 100 index has risen by a paltry 20%. This equates to an annualised capital gain of just 0.8%. Although this figure does not include the impact of reinvested dividends, and therefore does not paint a full picture of the index’s true investment performance over recent years, it nevertheless highlights that many of its holdings are unlikely to be overvalued.

Indeed, the FTSE 100 index currently yields around 3.6%, even after surging by 13% over the past six months. By comparison, the S&P 500 index yields just 1.4%. This suggests that rather than now being ‘overvalued’, the FTSE 100 index’s constituents are more likely to have moved from being “grossly undervalued” to just plain “undervalued”. As such, income investors can still obtain a very generous dividend yield, both on a standalone basis as well as relative to other stock market indices and asset classes, alongside income growth and further capital gains.

Source: Refinitiv as at 9 May 2024. Bond yields are distribution yields of selected Royal London active bond funds (end March 2024), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 7 May. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (3 May). *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 8 May.

Dividend growth potential

An improving economic outlook is a key reason for the FTSE 100 index’s recent rally. Investors are looking ahead to a continued fall in inflation that will ultimately allow central banks to cut interest rates from their current multi-decade highs. While this process is arguably not progressing as quickly as many investors had hoped for, with inflation having been stickier than expected, it is nevertheless widely forecast to continue falling in the coming months.

Lower inflation that brings an end to the cost-of-living crisis and falling interest rates that encourage spending instead of saving among consumers, are likely to prompt improved operating conditions for FTSE 100 companies. This should equate to higher profits that allow them to increase dividends. Indeed, shareholder payouts are likely to rise at a significantly faster rate than inflation as the pace of price rises becomes far more in keeping with its historical average than has been the case over recent years.

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Monetary policy which becomes more accommodative in response to falling inflation is also likely to persuade investors to become less risk averse. It should prompt a much improved rate of economic growth that raises demand among investors for riskier assets such as equities. This could provide further capital gains for investors in FTSE 100 stocks, with the index having the potential to reach new highs alongside the provision of a generous and rising income in the years ahead.

A global outlook

With the FTSE 100 being a globally focused index due to over 75% of its members’ sales being generated from outside the UK, it offers a significant amount of geographic diversification that equates to reduced risk for investors. The index’s constituents should also benefit from central banks in the US and the eurozone being in a very similar position to their UK counterpart, in terms of inflation falling and interest rate cuts being on the near-term horizon.

Furthermore, the index contains a wide range of high-quality companies that have well-covered dividends, solid competitive positions and sound balance sheets. Their size and scale means they are less risky than smaller peers, while their low valuations mean they offer wide margins of safety.

Having been overlooked for over two decades, FTSE 100 stocks offer excellent value for money in many cases and still represent a significant long-term buying opportunity for income-seeking investors.

Segro

Real estate investment trust (REIT) Segro (LSE:SGRO) offers an appealing income-investing outlook. The FTSE 100-listed warehouse owner and developer may have a relatively modest 2.9% dividend yield following its 16% share price rise over the past six months, but it has significant long-term dividend growth potential.

It is set to benefit from falling inflation and interest rate cuts that prompt higher consumer spending, with 43% of its tenants being either logistics companies or retailers. They are likely to experience higher demand as discretionary spending increases, with a longstanding trend towards online shopping set to resume following a marked decline as physical stores reopened after the pandemic. Indeed, over a quarter of all UK retail sales are now conducted online. This compares with less than 11% a decade ago.

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Segro should also benefit from a lack of supply of warehouses, particularly in urban areas where competition for land is high, that drives rental income upwards. Having recently raised over £900 million in a placing that will be used to expand its portfolio and boost its development pipeline, the firm is in a strong position to capitalise on an improving economic outlook.

The company was already financially sound prior to the share placing, with its latest annual results showing that interest payments were covered three times and its loan-to-value ratio stood at a relatively modest 34%. It raised dividends per share by 5.7% in the latest financial year, with further inflation-beating growth likely after an encouraging performance in the first quarter of the current financial year.

Trading on a price-to-book ratio of around one, the company’s shares are attractively priced and continue to offer a margin of safety. Its exposure to the European, as well as UK economy provides diversification benefits, while its long-term growth potential means it remains a worthwhile income investment opportunity.

GSK

GSK (LSE:GSK) also offers a favourable long-term income investing outlook. Although its 20% share price rise since the start of the year means that its dividend yield has fallen to 3.3%, the company’s shareholder payouts are likely to increase over the coming years.

It expects revenue to rise by 5-7% in the current financial year, with core earnings per share forecast to increase by 8-10%. Although the company anticipates that dividends per share will rise by a more modest 3.5% this year, dividend cover of 2.7 suggests there is scope for shareholder payouts to increase at a much faster pace over the long run.

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Indeed, the firm is raising investment in its pipeline of new drugs to boost its financial prospects. In the most recent financial year, total research & development (R&D) expenditure rose by 14% so that it amounted to 20.5% of total revenue. And in the first quarter of the current financial year, the company further increased R&D spending by 17%. Since it has a net gearing ratio of 113% and net interest cover of around 10, the company’s financial position is sufficiently sound to enable it to continue to raise investment in its pipeline.

With the company becoming increasingly well placed to capitalise on demographic changes such as a growing and ageing global population, which should equate to a higher prevalence of non-communicable diseases such as cancer, its financial outlook is likely to improve. Its price/earnings ratio of 11.4 suggests that it offers good value for money and capital growth potential alongside its income investing appeal.

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