10 high quality dividend stocks for income investors

Stockopedia's Ben Hobson uses quality screening to identify 10 dividend stocks for income investors.

In his latest letter to Berkshire Hathaway (NYSE:BRK.B) shareholders, the billionaire investor Warren Buffett describes his group's investment portfolio as a "forest".

Berkshire's many and diverse businesses, he says, are its "economic trees". And like any portfolio, there's an array of specimens ranging from twigs to redwoods. A few are diseased and unlikely to be around a decade from now, while others are "destined to grow in size and beauty".

This is Buffett at his poetic best. And while Berkshire boasts an array of investment interests, his point about mixed specimens in a portfolio will ring true with many investors. 

After a spell of market volatility late in 2018, you'd be forgiven for wondering which stocks would stand firm in a market storm... and which are at risk of being flattened. Like Buffett himself, those who look for long term compounding returns tend to prize the income streams from solid, dividend-paying stocks. In times of turbulence, reliable dividends are appealing, but the strategy comes with challenges. So it's important to know what to look for in a good quality income stock. 

The appeal of dividends

The case for investing in dividend shares is strong. UK dividend payouts came close to hitting £100 billion last year. In 2019, the top 100 stocks are expected to yield 5%, according to Link Asset Services. Mid-caps are forecast to yield 3.3% and the average for the market is 4.8%. 

While these forecast yields are well above the long-term average, investors will always go looking for better. But the problem with exceptionally high yield is that it can mask problems elsewhere. When the market loses faith in a stock (and the sustainability of its dividend), and the share price falls, it can push the yield higher. So what seems like an attractive dividend may actually be at risk of being cut.

To avoid this, studies of equity income strategies suggest it's worth steering clear of the very highest yields altogether. Instead, it's preferable to mix reasonable yield with high company quality to try and ensure the payout is sustainable. In recent years, this has been a favoured approach by the quant teams at investment banks like Societe Generale and Credit Suisse. 

Screening for quality income

The idea behind Quality Income is that financially strong firms are less likely cut their dividend payouts. Typically it avoids the very highest yields in the market, preferring more modest yields in financially strong firms with low bankruptcy risk.

For the average individual investor, there are lots of possible metrics that can be used to measure financial health. It's a personal choice, but at Stockopedia we use the following rules:

●    A yield of more than four % (but less than 15 %).
●    A minimum market cap of £800 million.
●    Each firm should pass at least seven of the nine checks in the Piotroski F-Score. The F-Score looks for improving trends in a company's profitability, debt, liquidity, share dilution and operating efficiency. 
●    No obvious risk of bankruptcy risk based on another accounting checklist called the Altman Z-Score.
●    Financial stocks are excluded.

To get a broader view of each company's quality, we've also included Stockopedia's Quality Rank. This scores and ranks each company against a range of 'quality' measures and brings them together in a single number - the higher the better. 

Here are some of the stocks currently passing these rules:

Source: Stockopedia

Over the past year, housebuilders like Persimmon (LSE:PSN) and Bovis (LSE:BVS) have been regular contenders on on this screen. The same goes for mining stocks like EVRAZ (LSE:EVR) and BHP (LSE:BHP). But there are more diverse options as well, including firms like Royal Mail (LSE:RMG), the specialist polymer business Victrex (LSE:VCT), used-vehicle marketplace owner BCA (LSE:BCA) and the airline easyJet (LSE:EZJ).

Overall, periods of market volatility are a reminder of the attraction of dividends - and why investors like Warren Buffett put so much value in them. But in the search for income, very high yields need careful handling. They can be a warning of trouble ahead. Taking a Quality Income approach to dividend stocks could be a safer option. It won’t always protect from dreaded dividend cuts, but there’s evidence that avoiding the very highest yields in favour of owning better quality stocks is a more profitable endeavour.

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