When analysing market trends and corrections, one thing to emerge is that income stocks have outperformed the wider market by an average of 28 per cent (on an annualised basis) since 2000.

We have screened our favoured UK and European holdings and split them into two sets. The first contains stocks where we feel the first-year dividend is safe, such is the level of cover and cash generation. The second set is risky, with lower dividend cover, but offers potentially higher rewards.

High dividends
BP and Shell are pursuing favourable capital management programmes in the UK. We are overweight in BP because of its high-quality upstream assets and high-margin oil and gas production growth. BP’s dividend payment is directly linked to oil prices, with the management stating it expects to return US$65 billion in dividends and buy-backs between 2006 and 2008, if crude oil prices average $60 per barrel.

Aviva, with its highly cash-generative property and casualty division, has a premium yield in the life insurance sector. Management repeatedly states its preferred mechanism of returning capital through increasing dividends.

Sustained growth
In pharmaceuticals, AstraZeneca intends to continue growing dividends in line with earnings, which implies the risk from patent challenges may affect dividend growth from 2009. However, the group’s target of two times dividend cover (currently 2.2 times) will buffer growth for the next few years.

In Europe, energy company Eni aims to maintain the top dividend yield in its sector, while Total’s management has also stated its preference for dividends as a form of shareholder remuneration. We are forecasting dividend growth of 15 per cent, with potential for upside over the medium term.

In financials, Banco Santander has a history of strong earnings growth from diverse business activities. We expect dividends to grow in line with earnings.

Low dividends
For the second set of ‘riskier’ dividends, we looked at stocks with greater dividend yield than the market and low dividend cover. It should be noted that these stocks feature in our UK and European models, so implicitly we believe the likelihood of a dividend cut is low.

Despite rumours to the contrary, the UK banks made no dividend cuts at the full-year results. 2008 will be more difficult for the progressive dividend policies favoured by the likes of Bradford & Bingley. Larger names, such as HSBC, benefit from a meaningful excess capital position, and we believe its progressive dividend policy will continue.

Royal Bank of Scotland increased full-year dividends by ten per cent, despite worries about its capital ratios. We expect dividends to stay progressive due to its diversified sources of cash flow.

Greater risk
William Hill is a riskier income stock. Dividend cover is low and net debt high at 3.5 times EBITDA, but the stock is trading at the low end of its five-year PE range and looks good value. National Grid (which appears in the ‘low cover’ category because of its high payout ratio) offers a combination of high dividend yield and strong dividend growth, supported by predictable cash flows from infrastructure assets.

In insurance, Admiral is another stock where the management’s decision to pay out the majority of earnings (80 per cent) in dividends ensured that the stock is in our higher-risk category. Our forecasts include the annual ‘special’ dividend, which is often not included in other published forecasts, but has consistently been paid out in past years.

Popular telecoms
The attraction of telcos is high dividend yield. All our recommendations in the UK
and Europe (Vodafone, France Telecom and Telefonica, plus Vivendi as a telecommunication proxy) have above-average yields, set to continue thanks to strong cash generation. Telcos have high free cash flow yields and operate a balanced strategy between organic investing, making strategic acquisitions and returning cash
to shareholders.

Henk Potts is equity strategist at Barclays Wealth