Securing high yield is not as straightforward as it sounds, but Stockopedia's Ben Hobson tells us how to avoid dividend traps and names 10 of the best dividend payers around.
In times of market uncertainty, strong, reliable dividend paying stocks tend to find favour. One problem is that investors searching for income can often be blinded by high yields, only to find that the payouts from these so-called 'dividend traps' are cut soon afterwards. So it's important to understand what to look for in a good quality income stock.
The case for investing in dividend shares is strong. UK dividends rose by 4.1% to £32.3 billion in the third quarter of this year - a record for the quarter. Resurgent mining and financial stocks have been propelling those payouts, but some sectors are struggling. Retail shares have seen their profits come under pressure recently and that’s put a cap on dividend growth.
Overall, analysts at Link Asset Services are forecasting that UK payouts for the whole of 2018 will reach £99.5 billion - a 4.8% rise for the year and a comfortable new record. The forecast yield on UK shares over the next 12 months now stands at 4.1%.
But as we've mentioned before in this column, many income investors shoot for better than average when it comes to yield. The risk of buying stocks on exceptionally high yields is that they can be a signal of trouble ahead. High yields are often caused by tumbling share prices, which in turn are triggered by uncertainty in the market about a firm's outlook. So high yields can end up leading to dreaded dividend traps.
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 host 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 4% (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.
|Name||Mkt Cap £m||Forecast Yield %||Piotroski F-Score||Quality Rank||Sector|
|Bovis Homes||1,285||10.9||7||92||Consumer Cyclicals|
|Barratt Developments||5,182||8.7||7||95||Consumer Cyclicals|
|BHP Billiton||81,396||6.6||8||97||Basic Materials|
|Dixons Carphone||1,947||6.6||7||65||Consumer Cyclicals|
|Rio Tinto||63,131||5.9||7||88||Basic Materials|
Source: Stockopedia Past performance is not a guide to future performance
On this 'quality income' basis, housebuilder are a dominant force at the moment. Many of these stocks have captivated investors in recent years because of their apparently strong balance sheets, low valuations and high yields.
Construction is a very cyclical sector and it's currently being assisted by government policy on encouraging new home buyers. Some investors will be wary of that. But for the time being, it's a profile that makes housebuilders like Bovis, Persimmon, Barratt and Galliford Try attractive against this strategy.
In times of downward market pressure like we saw in October, solid dividends can be an attractive option for some investors. But it's important to look at company quality rather than be mesmerised by a too-good-to-be-true yield.
Falling share prices can push yields up, so adopting some safety checks is important. The financial resilience of these firms ought to offer some protection from cyclical swings and the risk of dividend cuts. It won't always be the case, 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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