- What should investors look for in an income share?
- Rules must be relaxed after Covid, but tread carefully.
When we last ran our Alpha dividend yield screen the fall-out from Liz Truss and Kwasi Kwarteng’s disastrous “mini” budget had sent the yield on 10-year gilts (UK government bonds) above four per cent. The new regime of Rishi Sunak and Jeremy Hunt seems more in tune with financial reality and markets are reassured, with the 10-year benchmark bond yield now back at around 3.3 to 3.5 per cent.
Yields on sovereign debt matter to all investors, and especially to those who own shares for the dividends: if you can get a guaranteed yield on an asset that won’t default, then it follows you’d expect the offer of a higher rate of return from an alternative that does carry more risk of the payment being cut, missed or the issuing entity going bust.
It’s in this context that we examine the universe of UK shares to ask which dividend-payers are worth owning. For starters then, dividends ought to outstrip yields available on fairly low-risk bond funds (that invest primarily in zero-default risk government bonds and low default risk investment grade corporate bonds).
Another high priority is of course beating inflation over time. Real yields decline as the value of money gets eroded by rising prices. The advantage of owning shares is that companies often grow their dividend as they become more profitable and generate more free cash flow. So, even though companies will struggle to increase pay-outs in line with today’s sky-high inflation, when the rate of inflation moderates those firms that have shown a propensity to grow dividends should maintain a real-terms premium over bonds in the long-term.
How Covid-19 wrecked the rules for screening
The best place to look for the type of steady long-run dividend compounders that income investors prize is among the large cap universe. The characteristics to look for aren’t necessarily companies with the highest dividend yield. Companies with the highest dividend yield are often cyclical businesses that are on the edge of being hit in a downturn. Shares that have a lower yield now but with reasonable expectations they could grow their dividend faster are usually a better option for the buy-and-hold investor.
Other vital indicators are dividend cover (how many times dividends per share is covered by earnings per share), the track record and prospects for profits growth, having a positive free cash flow and how well companies cover other commitments such as the interest expense on their borrowings.
Finally, a sign of true commitment to maintaining a dividend is to have a strong track record of not cutting it. This last test would ordinarily be a strict rule for any company being considered as an income stock but the world is still emerging from the most extraordinary of times. Thanks to the damage wrought by coronavirus and the lockdowns of economic activity, some of the tests for our Alpha dividend screen have been greatly relaxed.
For our large cap screen, we have only two must pass rules: 1) the trailing dividend yield must be above three per cent; 2) the forecast dividend yield (current full year dividend per share estimates divided by share price) must be above three and a half per cent.
Other tests that would normally have been compulsory are therefore left as being only indicative, which means we aren’t screening out a lot of companies that will be good dividend payers after the pandemic because they had to cut their pay-out in the midst of the crisis.
Naturally, that also means some companies that would probably not have made the cut in usual times are on the short-list, but that’s why it is more important than usual to exercise discernment when appraising their merits. As ever, screening is only a first step in stock-picking, but in this report we run through some of the questions to be asked of candidates for a UK large cap income portfolio.