Understanding the stock market

Dorothy Parker, the American writer, once remarked: "Two of the most beautiful words in the English language are `cheque enclosed'." In the latest in our series on the stock market, John Andrew discusses how to make these magic words appear before our eyes on a regular, and generous, basis.

Shareholders are part owners of a company. Should all go well, they will receive a share of their company's profits, known as dividends, usually twice a year. However, companies do not pay out all of their profits to their shareholders.

A proportion is retained to plough back into the business. Technically, undistributed profits are "transferred to reserves" in years when the profits are not as good, so the company can pay dividends from reserves.

When a company prospers, shareholders' rewards are two-fold. In addition to receiving a regular income, they will also hopefully see their shares increase in value.

This is because the profits retained in the business will be put to good use. In turn, this should increase earnings and therefore the value of the business. The result to the shareholder will hopefully be an increasing share price, with dividends rising each year.

This sounds ideal - in theory. However, if you look at The Independent's shares page, you will notice that returns are generally low.

High returns are usually associated with riskier shares. The yield column on the page expresses the last gross annual dividend as a percentage of the current share price. It is the exception rather than the rule to find a gross yield above 5 per cent - most produce less.

Investors who are seeking income from their shares will no doubt be disappointed, as they can generally secure higher returns from simple savings accounts.

Naturally everyone needs a contingency level of savings which provide instant access.

It is also true that higher returns can be obtained from notice or fixed- term accounts. However, maximising short-term returns with savings accounts can be to the detriment of future income.

It is essential for every investor to have a comfort level of savings.

It is equally important for those who will be relying on investment income to consider taking steps to ensure that their income increases over time, even if this means forgoing income in the early years.

This may not be a route that everyone is able, or indeed would wish, to take. It requires planning and professional guidance.

Ideally, in addition to funds in instant access and term accounts, consideration should be given to securing a guaranteed level of income.

This may be achieved by investing in gilts, which are Government securities. These were the subject of this column last month when it was explained that when the current price for a dated gilt is more than pounds 100, it means that the investor will make a loss when the security is redeemed.

Although such gilts pay a high dividend, it must be understood that a proportion of the income paid every year is effectively capital.

When investing for income, the advice is usually that 40 to 50 per cent of a portfolio should be in securities producing a fixed level of income.

If contemplating investing in gilts, professional advice should be sought from a stockbroker or independent financial adviser (IFA).

However, ordinary gilts do not give protection against inflation. An alternative course would be to invest in a fixed interest unit trust.

John Hutton-Attenborough, of IFA Berry Birch & Noble, says it may be worth contemplating the Commercial Union Income Unit Trust which currently yields an income of 7.6 per cent.

This need not be to the detriment of the invested capital. Over the past 12 months, a pounds 1,000 investment would now be worth pounds 1,177 if dividends had been invested. Over five years pounds 1,000 would have risen to pounds 1,780, which is an annual growth rate of 12.2 per cent.

In effect, the fund has grown by a considerable amount more than the amount paid in income over the years.

So as to spread the risk, any shares portfolio should contain at least six holdings spread across different sectors.

In order to absorb the cost of buying and selling the shares, the minimum economic holding per share is around pounds 2,000.

This may not be affordable by more modest investors. However, there is a solution - unit trusts which invest in a mixture of fixed income stocks and shares.

Mr Hutton-Attenborough says the Jupiter Income Unit Trust is well worth considering. With income reinvested, the return over the past year has been 21.6 per cent and an annual equivalent of 27.5 per cent over the past five years.

However, the dividend yield is only 3.7 per cent. This means that pounds 1,000 invested a year ago would have produced an income of just pounds 37.

At the same time, pounds 1,000 invested five years ago would now produce an annual income of pounds 124.51, which is equivalent of 12.45 per cent gross.

This emphasises the fact that that when investing in the stock market for income, one should take a longer-term view and be willing to sacrifice a low initial income for higher dividends later.

Readers contemplating investing in the stock market for income are recommended to seek professional advice.