The Income Investor: two dividend stocks with capital growth potential

Capital growth is not usually the primary goal for income seekers who invest in the stock market. Generous, reliable and growing dividends, for instance, are usually deemed to be of far greater importance.

A larger portfolio in monetary terms, however, generally makes it easier for investors to achieve their income goals. But with the FTSE 100 index falling by 0.4% since the start of the year, and the FTSE 250 declining by 5.7% over the same period, generating capital growth has become increasingly difficult for equity investors.

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Unfortunately, the same factors that have held back the stock market over recent months could persist in the near term. An inflation rate of 6.7% shows that fast-paced price rises are proving to be far stickier in the UK than in the US or Europe, where inflation currently stands at 3.7% and 2.9%, respectively. Although the Bank of England held interest rates at 5.25% at its two most recent meetings, there is still the risk of further rises in Bank Rate while the rate of price growth stands at more than three times the central bank’s target.

Higher-for-longer interest rates mean economic activity will almost inevitably be held back. We'll get an updated economic and fiscal outlook from the Office for Budget Responsibility in the Autumn Statement on 22 November. But the Organisation for Economic Co-operation and Development (OECD) said in September it thinks the UK economy will grow 0.3% in 2023. That’s unlikely to encourage investor demand for FTSE 350-listed companies, thereby acting as a drag on their performance. Investors should, therefore, prepare themselves for the possibility of limited capital gains over the coming months.

Long-term capital growth potential

However, the stock market is extremely likely to deliver long-term capital growth that far exceeds that of other mainstream income-producing assets. When combined with the dividend appeal of a multitude of listed companies, equities suddenly become a highly enticing proposition for income-seeking investors vis-à-vis cash and bonds.

Crucially, inflation is expected to fall below 5% by the end of this year and 2% by the end of 2025, according to the Bank of England, which means economists now think interest rates will finally start to decline in the third quarter of next year. Some, including the EY ITEM Club, think rates may start to fall as soon as May 2024. Either way, this is likely to have a positive impact on GDP growth and spur greater demand for UK-listed stocks.

Alongside this, the global economic outlook is likely to benefit from similar trends over the coming years. In the US, for example, the Federal Reserve expects to cut interest rates from their current level of 5.25-5.5% to below 4% by the end of 2025. And with inflation now within touching distance of its 2% target, a more dovish monetary policy is likely to be implemented by the European Central Bank. These changes are likely to act as positive catalysts on the world economy, on which many UK-listed stocks depend.

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The past performance of equity markets also suggests that the current era of lacklustre capital growth is almost certain to end. The FTSE 100 and FTSE 250 indices have always recovered from even their very worst periods of decline to post new record highs. Although investor sentiment is understandably weak at present in response to dire economic data, the cyclicality of the stock market and economy means that now could be a highly opportune moment to purchase a range of undervalued, high-quality stocks.

Avoiding potential value traps

Indeed, numerous FTSE 350 shares trade at extremely attractive prices, which suggest they have scope to deliver significant capital gains over the long run. Low share prices also mean, in many cases, that yields are relatively high and compare favourably with the wider stock market, as well as with other mainstream income-producing assets.

Of course, income investors should not merely purchase the cheapest, or highest yielding, stocks they can find. In many cases, lowly-priced shares are cheap for a reason. They may, for instance, have large debt levels that will place growing pressure on their financial prospects in the current era of interest rate rises and weak economic growth. Or they could lack a clear competitive advantage that means profits, and thereby share price prospects, are highly underwhelming compared with sector peers.

Instead, income investors should purchase high-quality companies that have market valuations which are temporarily low and do not fully reflect their long-term potential. In doing so, they can benefit from a generous and growing income return which is supplemented by strong capital gains that ultimately lead to a larger portfolio in monetary terms.

Positioned for growth

While the Sainsbury (J) (LSE:SBRY) share price has rallied 26% since the start of the year, the supermarket still trades on a relatively attractive valuation. Its price-to-earnings ratio, for example, is around 12.8. Meanwhile, its dividend yield stands at roughly 4.8%. Shareholder payouts were covered a healthy 1.8 times by underlying profits last year, which suggests they are highly affordable even during a tough period for consumer-focused companies.

The firm’s recently released half-year results showed that retail sales (excluding fuel) rose by 8.4% on a like-for-like basis. Although its retail underlying operating profit margin declined by four basis points to 2.91%, the company was able to increase its market share. This positions it for future growth, while a falling inflation rate and an improving economic outlook are set to bring the cost-of-living crisis to an end. Other things being equal, this should mean that shoppers become less price conscious, which is likely to put less pressure on industry profit margins over the coming years.

Sainsbury’s first-half results also stated that it now expects full-year underlying pre-tax profits to be in the upper half of its previous guidance range, while retail free cash flow is forecast to be 20% higher than the prior expectation of at least £500 million.

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With the company well placed to capitalise on a longstanding trend towards online shopping, which has recommenced after digital sales sharply declined in the immediate aftermath of the pandemic, it has a competitive advantage over no-frills competitors that only operate from physical stores. And with its operating environment set to significantly improve, the company’s shares offer capital growth potential over the long run.

Long-term growth catalysts

Mining company Glencore (LSE:GLEN) also offers long-term capital growth potential as a result of its attractive valuation. Having fallen by 21% since the start of the year, its shares now trade on a forward price-to-earnings ratio of around 9.5. Based on dividends announced for the 2022 financial year of 36p per share, the stock yields around 8.3%, with shareholder payouts covered roughly three times by underlying profits.

While the firm’s latest production update stated that full-year nickel production is now expected to undershoot previous guidance due to maintenance issues and strike action, its copper, zinc, coal and cobalt output is in line with prior forecasts. Furthermore, it continues to anticipate that full-year profits from its marketing division will be ahead of long-term guidance.

An improving global economic outlook is set to catalyse the company’s share price. A combination of falling inflation, lower interest rates and improved GDP growth is likely to prompt higher demand for an array of commodities. Its pivot to future-facing commodities, such as those used extensively in electric vehicles and renewable infrastructure, is also likely to prompt higher profits and share price growth, as the world’s transition to net zero continues.

Certainly, the performance of mining stocks has historically been volatile. Therefore, from an income perspective, there are more consistent dividend payers than Glencore. But its low valuation, high yield and improving share price outlook adequately compensate investors and mean that it represents a favourable risk/reward opportunity on a long-term view.

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