* To buy back 1 billion pounds of shares over two years
* To invest 3 billion pounds over 3 years on more stores
* Year underlying profit 869 million pounds vs forecast 861 million
* Takes 10 percent stake in U.S. online grocer FreshDirect
* Shares up 2.3 percent vs European sector up 0.2 percentt
(Adds more detail, updates shares)
By Mark Potter
LONDON, March 10 (Reuters) - Britain's Wm Morrison Supermarkets plans to return cash to shareholders and step up spending on new stores and the internet as it battles to lure investors and shoppers alike in a tough economic backdrop.
Britain's fourth-biggest grocer said on Thursday it would buy back 1 billion pounds ($1.6 billion) of shares over two years and hike its annual dividend by at least 10 percent for the next three years.
It will also invest around 3 billion pounds over three years to accelerate new store openings, test convenience stores and launch an online business.
To help prepare for the latter, Morrisons said it was spending 32 million pounds on a 10 percent stake in U.S. internet grocer FreshDirect.
The group said it could both reward shareholders and invest thanks to its strong performance, with profit before tax and one-off items up 13 percent to 869 million pounds in the year to January, helped by a focus on low prices and fresh foods.
That was ahead of analysts' average forecast of 861 million, according to Thomson Reuters I/B/E/S Estimates.
However, it also reported a slowdown in sales growth in recent weeks and said Britain's grocery market was likely to remain subdued in the coming year.
Retailers across developed economies face difficult trading conditions as shoppers struggle with rising food and fuel costs, subdued earnings growth and job insecurity as governments drive through austerity measures to cut their deficits.
Home Retail, Britain's biggest household goods group, issued a profit warning on Thursday, while Belgian grocer said cost cuts helped it to beat fourth-quarter profit forecasts.
Morrisons shares trade at a discount to rival grocers like Tesco, Wal-Mart's Asda and J Sainsbury, largely because it has been slower to diversify.
Arden Partners analyst Nick Bubb said its plans could help to close the gap, which is 15 percent with Sainsbury, though chief executive Dalton Philips needed to convince investors that the new investments would accelerate growth in a tough market.
Espirito Santo analysts said the step up in new store openings could raise concerns about investment returns, with all other major British grocers pledging to expand rapidly.
At 1010 GMT, Morrisons shares were up 2.3 percent at 286.8 pence, the biggest rise on the UK's benchmark FTSE-100 index and compared with a 0.2 percent increase in the STOXX Europe 600 retail index.
GROWING IN A TOUGH MARKET
Morrisons, which runs around 440 stores and unlike rivals produces much of the food it sells, said it planned to open 2.5 million square feet of new selling space in the three years to January 2014, compared with its previous target of 1.5 million square feet over the three years to January 2013.
That could include convenience stores, with the first of three trial stores under the name "M local" to open in July.
The group will also look to expand online, with its purchase of a stake in FreshDirect adding to its acquisition of baby goods website Kiddicare in February.
The deal with FreshDirect could dampen rumours that Morrisons might bid for British online grocer Ocado.
Morrisons said it also aimed to free up 750,000 square feet of selling space in its stores from rationalising its ranges, which could create room for more non-food goods like clothing.
It will step up investment in its own-brand ranges as well.
Sales at stores open at least a year rose 0.5 percent, excluding fuel and VAT sales tax, in the fourth quarter of its financial year, down from the 1.0 percent rise reported for the first six weeks of the period.
Morrisons, which hiked its dividend by 17 percent to 9.6 pence a share, said Britain's grocery market was likely to grow at a similar pace this year than last, when researchers Kantar say sales rose 3.4 percent, the slowest rate for five years. ($1=.6194 Pound) (Editing by Kate Holton; Editing by Jon Loades-Carter)