How to find the most reliable dividend stocks

The FTSE 100 lists 26 so-called 'dividend kings'. However, assessing the income-paying credentials of UK and overseas-listed stocks requires considerable care.

The one attribute that income investors arguably prize over any other is consistency – particularly those who use their investments to fund or supplement their lifestyles in retirement. For this growing band of investors taking advantage of the pension freedoms, a dividend cut is likely to hit the income they pay themselves in retirement. To deal with any shortfalls in this ‘natural’ investment income, investors in this situation have two options: to dip into their capital or lower their income requirements – in other words, take less out of their pension pots.

To avoid falling into the dreaded ‘value trap’ by buying a share that will ultimately disappoint in terms of income, investors should look out for various value trap warning signs.

Dividend kings

Fund managers consider a number of factors in their hunt for the most reliable dividend-paying companies – those that should in theory keep the dividend cheques arriving for many years. One characteristic they look for is a reputation for consistent dividend payments. Determining this involves a bit of digging through a firm’s reports and accounts.

Those firms that have increased their dividends for 10 years or more are dubbed ‘dividend kings’. Number-crunching for Money Observer has found that an impressive 26 companies in the FTSE 100 index have achieved this feat since 2008. As Russ Mould, investment director at AJ Bell, points out, a 10-year dividend track record is some achievement, particularly when the period began with the global financial crisis. He says: ‘It is testament to the strong competitive position that firms have built, and to their strategy, management acumen and financial strength.’

As well as delivering on the income front, the 26 companies have also come up trumps in capital terms. Just three of them, Imperial Brands, Vodafone and SSE, failed to beat the FTSE 100 index capital return of 24.1 per cent over the past decade (to 14 May). On a total return basis the picture is even better: 25 of the 26 names have beaten the index, with SSE the outlier. The above table ranks the dividend kings, with Ashtead, Hargreaves Lansdown, Croda, DCC and Halma taking the top five spots on a total return metric.

Overall, the average dividend king has produced a total return of 535 per cent over the 10-year period, compared with the FTSE 100’s return of 81 per cent. It is therefore not much of a surprise that consistent dividend payers also attract the attention of investors with a primarily capital focus. One such is Richard Power, manager of the Octopus UK Micro Cap Growth fund.

Power notes that for investors looking for ‘tomorrow’s winners’ outside of the FTSE 100, consistent dividend payments are a sign of ‘maturity’. He says: ‘For young businesses, regular dividends indicate that progress is being made, that a company has gone through its teenage years and is now a bit more grown up.’ Two small-cap dividend kings are Youngs and James Halstead, while Power names Watkin Jones and Telford Homes as two up-and-coming consistent dividend payers.

Moreover, over the long term, reinvesting dividends literally pays dividends, thanks to the power of compounding (whereby dividends are used to buy more shares, which in turn generate additional dividends, and so on). According to the 2018 Barclays Equity Gilt Study, which charts historic returns for UK equities, bonds and cash, a £100 investment at the end of 1899 would be worth just £203 in real terms without the reinvestment of dividend income. But with reinvestment, the £100 would have grown to £34,758.

Global opportunities

Other developed markets – the US and European markets – also have plenty of dividend kings. Examples in the US include Johnson & Johnson, PepsiCo, Cisco, Coca-Cola and Procter & Gamble. In Europe, examples of stocks that have raised dividends for 10 years or more include Nestlé, Kone, Wolters Kluwer, L’Oreal and Roche.

According to Ben Peters, co-manager of the Evenlode Global Income fund, the dividend kings that should stand the test of time, all things being equal, have similar attributes. He says: ‘Quality companies – those that are market leaders and have strong barriers to entry – are more likely to increase their dividends sustainably.’

Delve into the dividend

Private investors, though, should not blindly pick a stock just because it has a long track record of growing dividends. Other quantitative factors should be measured, including whether dividends can be paid easily out of cash flow without straining the balance sheet. Free cash flow cover, viewed as one of the key metrics for dividend sustainability, is a useful aid.

Peters says: ‘Free cash flow is the spare cash flow available at the end of each year – after all expenses, interest, tax and capital investment – to sustain and grow a company’s dividend. A business whose dividend is not covered by free cash flow uses borrowings to fund some of its dividend, a practice that is clearly unsustainable over the long term.’

Another key indicator of dividend sustainability is dividend cover. This is considered an important metric in assessing whether a company is in a healthy position to distribute the level of dividends it proposes to. The metric is calculated by dividing earnings per share by dividend per share.

As a rule of thumb, a low dividend cover score – of around one times or lower – suggests that dividends are vulnerable, as the company is using most, if not all, of its profits to fund its dividends. A figure of two or more times is viewed as comfortable, because it is a sign that a business is not over-distributing.

However, Kevin Murphy, co-manager of the Schroder Income fund, argues that looking at a firm’s dividend track record is meaningless. He says: ‘I don’t pay any attention, as ultimately all of those dividends have already gone to other people.’

It is true that backing companies with strong track records is a far from flawless strategy: various dividend kings have lost their crowns over the past couple of years after taking an axe to their income payments. Pearson, Tesco, Rio Tinto and BHP Billiton are examples of stocks that have brought their 10-year plus dividend growth streaks to a juddering halt over the past couple of years.

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In each case, share prices took a hammering on the day the dividend cut was announced. Pearson, for example, saw its share price fall by 30 per cent. However, as Mould points out, all of them have started clawing their way back. He says: ‘In each case, management initiated a turnaround programme. Pearson is still in the early stages of its plan, but Tesco has now returned to the dividend list, having previously cut its payout altogether. Rio Tinto and BHP Billiton once more offer juicy yields, having cut costs and capital expenditure, and benefited from rising commodity prices.’

It is unwise to be seduced by management pledges to increase or maintain dividends: such promises can easily be broken. Furthermore, management teams need to successfully juggle dividend payments with growing their businesses, either organically or through acquisitions. Those that fail to do so risk investing too little back into their businesses, which will ultimately stunt profit growth.

‘A dividend winning streak can lead to bad behaviour on the part of the management team,’ says Murphy. ‘For example, if the dividend is over-prioritised, as the management team tries to keep the run going, this can lead to dividend payments strangling a business, as there is insufficient money left over to grow it.’

Robust and consistent rules

Andrew Herberts, head of private investment management at Thomas Miller Investment, agrees. He says: ‘The dividend is clearly an important component of returns, but no single measure is enough to capture the profile of a successful investment. Personally, I prefer simple, robust and consistent dividend rules, with a sufficient cushion to allow [dividend] smoothing if required, such as a limited subsidy of dividends in temporarily poor periods. This means no one should be surprised at a dividend cut, because it is solely a function of corporate conditions.’

Just as important as delving into the fine detail to fathom whether dividends will prove sustainable is carrying out some qualitative analysis, such as assessing a company’s products and services in relation to those of its competitors. ‘Over time, all business models will be tested and challenged,’ says Peters. ‘At the moment, technological change is the focal point, but in future it will be something else, so it is important that a business keeps on evolving.’

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