The Income Investor: don’t miss these reliable income opportunities

An uncertain economic outlook means many income investors may currently be shying away from dividend stocks. After all, dividends can ultimately only be sustained when profits are made. And with the UK facing a challenging near-term outlook that includes above-target inflation, heightened interest rates and weak economic growth, the reliability of dividend payouts could realistically decline if corporate performance deteriorates.

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In place of dividend shares, many income-seeking investors may be holding cash or purchasing bonds. High interest rates mean that their yields have become relatively appealing. And, as long as rates remain high, they also offer highly reliable income payments that, in the case of cash savings and gilts, are almost risk free.

Industry considerations

However, not all dividend stocks are created equal. Some have more reliable shareholder payouts than others. While investors in dividend shares will never be able to achieve the near risk-free status of cash and UK government bond income returns, they can nevertheless reduce their chances of experiencing dividend cuts by investing in firms that meet specific criteria.

For example, a company that is relatively unreliant on the economy’s performance is likely to have a more dependable dividend compared with cyclical firms. Although defensive stocks may not offer the same potential for dividend increases over the long run vis-à-vis growth companies, they are likely to be more appealing to income investors who prioritise the reliability of shareholder payouts over their rise.

In addition, firms that operate in an industry where barriers to entry are high may experience a more stable financial performance that means dividends are more consistent. Such companies may not need to continually respond to the threat of new entrants by lowering prices or investing large sums in new products or technology. Firms with a significant competitive advantage over their peers, such as through a high degree of customer loyalty, may also be more successful in maintaining dividend payments during a weak economic period.

Solid fundamentals

Although past performance is never perfectly mirrored in future returns, a company’s track record of dividend payments provides guidance on their future reliability. A firm that has continually cut, postponed or cancelled dividends may, for instance, be a less dependable prospect than a company that has a solid track record of shareholder payouts.

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The number of times that dividends are covered by profits also provides an indication of whether shareholder payouts are affordable and can continue at their current, or higher, level. By dividing annual earnings per share by annual dividends per share, investors can assess the headroom that a company had when making its latest shareholder payout. Although determining a desirable level of dividend cover is highly subjective, and is partly dependent on the stability of the firm in question, a figure of less than one means dividends are likely unsustainable at their current level.

Additionally, a solid balance sheet may equate to reduced risk from an income investing perspective. This is especially true during the current period of elevated interest rates, where debt refinancing is set to prompt a significant increase in interest payments that further dilutes net profits and reduces the affordability of dividend payments. Generous headroom when making interest payments on existing debt, calculated by dividing operating profits by net finance costs, is another indicator of financial strength that may be particularly desirable for income seekers at the present time.

A margin of safety

Of course, even selecting what appear to be the most reliable income stocks does not guarantee that they will ultimately prove to be dependable dividend payers. Unexpected events that prompt dividend cuts can take place in any industry without prior warning.

Therefore, it may be prudent for income-seeking investors to demand a margin of safety when purchasing dividend stocks. This is most likely to take the form of higher yields than required so that if a company is forced to cut dividends, its income return is still high enough to maintain an investor’s current standard of living.

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Since a wide range of FTSE All-Share incumbents currently trade on low valuations, due in part to the current unpopularity of UK-listed stocks, several companies have relatively high yields. Buying a wide range of them, rather than simply holding cash or government bonds, could provide a more attractive income return as falling inflation, interest rate cuts and an improving economic outlook prompt a faster pace of dividend growth.

Source: Refinitiv as at 4 December 2023. Bond yields are distribution yields of selected Royal London active bond funds (30 September 2023), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 30 November. LIBOR is interest rate that banks lend money to one another (3 month GBP LIBOR as at 1 December). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 4 December.

Tobacco stocks still have income appeal

With a dividend yield of 7.9%, tobacco firm Imperial Brands (LSE:IMB) offers an extremely generous income return. Its recently released full-year results showed that shareholder payouts rose by 4% on a per share basis, with its defensive business model relatively unaffected by a sluggish global economy.

Indeed, the tobacco sector offers a highly reliable income outlook. Since demand for cigarettes is relatively price inelastic, which means demand is largely unaffected by price changes, tobacco firms have vast pricing power. This allows them to raise prices no matter what the economic or consumer outlook, thereby providing a dependable income return that has historically grown over the long run.

Of course, tobacco stocks face increasingly onerous regulations as governments seek to limit the health impacts of smoking. But with the potential for growth in next-generation products such as e-cigarettes, as well as a continued requirement for governments to generate tax revenue amid elevated levels of national debt, the outlook for the tobacco sector remains relatively upbeat. In fact, Imperial Brands recorded a 26% rise in next-generation products sales in the full year, as it seeks to adapt to evolving consumer trends that include growing demand for reduced-risk products. 

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Having slashed dividends per share by a third in 2020 to reduce debt levels, the company has grown shareholder payouts in each of the past two years. Dividends are now covered 1.7 times by net profits, while net interest payments were covered over eleven times by operating profits in the 2023 financial year. Both of these figures suggest that dividend cuts are unlikely to take place. Therefore, with a high yield, defensive credentials and a sound business model, Imperial Brands offers a relatively reliable income investing outlook.

A strong track record of dividend growth

So, too, does National Grid (LSE:NG.). The electricity transmission and distribution firm currently yields 5.4%, with it having raised dividends per share in each of the past 10 years.

This is extremely impressive given that the pandemic prompted a whole host of income stocks to cut shareholder payouts in 2020. And with the firm’s dividends currently covered roughly 1.3 times by net profits, there is sufficient headroom to suggest they will prove to be highly reliable.

The company’s dividend policy is to raise shareholder payouts in line with CPIH inflation, which is CPI inflation plus owner occupiers’ housing costs. Its recently released half-year results showed it is performing in line with previous financial guidance, with its defensive credentials meaning it is relatively unaffected by the economy’s weak performance. And while a net debt-to-equity ratio of 149% is undoubtedly high, the relative stability of the firm’s business model means it is acceptable.

National Grid’s pivot from gas to electricity transmission and distribution over recent years means it is more closely aligned with an evolving energy market as net zero ambitions are realised. With an excellent track record of dividend growth, defensive characteristics and plans to match its growth in shareholder payouts to CPIH inflation, the company offers a dependable income investing outlook.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.