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How to use a dividend growth strategy to find resilient income shares

Wednesday, February 15, 2017 7:23
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Income investors were under the cosh right from the start of 2016. The outlook for dividend growth in many companies was close to zero and billions of pounds of cuts were forecast. As it turned out, the devaluation of the pound after the EU referendum helped jet-propel dividends late last year. But beneath the surface, that all-important growth was still lacking and uncertainty still abounds.

The uncertainty is made worse because there are so many moving parts in the dividend outlook. On the upside, economic growth seems to be holding up in the UK, parts of Europe and the US. Plus the lower pound will probably boost dividends again in 2017.

But not every company will benefit. The unknown impact of Brexit negotiations, rising input inflation and pressure on earnings in some sectors, mean there are likely to be bumps in the road this year. But dig into the dividend growth track record of companies and it may be possible to find those that are better placed to ride-out those bumps.

How the falling pound affected dividends

The fall in the value of sterling has had a big impact on UK dividends because two-fifths of them are paid in dollars and euros. So the exchange rate has made them worth more in sterling.

Dividends from UK companies last year, including special ‘one-offs’, rose by 6.6% to £84.7bn according to the Capita UK Dividend Monitor. That’s a decent rise of £5.2bn, but £4.8bn of it was down to the weaker pound. When you strip out exchange rate gains and one-offs, underlying dividends actually fell 3.7% year-on-year to £73.7bn.

An interesting feature of UK dividend data is the big influence of a small number of companies. Last year, Royal Dutch Shell hiked its payout by £3.2bn to £11.1bn, which made it the biggest dividend payer in the world. Together with BP, HSBC, GlaxoSmithKline and Vodafone, the top five companies accounted for 38% of all the UK dividends paid in 2016.

But more broadly, just 26 out of 39 sectors managed to produce a year-on-year dividend rise in 2016, which Capita says is below the 32 sector average since the financial crisis. And while dividends are forecast to grow in 2017, the outlook remains very uncertain.

A track record of dividend growth

Faced with this uncertainty, one option for income hunters is to redouble efforts towards finding stocks with the best track record of growing their dividends. Dividend growth can be seen as a signpost to well-managed firms with growing earnings and progressive dividend policies.

This was the sentiment of ex-Fidelity fund manager and investing legend Peter Lynch, who wrote: “The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row.”

Finding dividend growth streaks like that in the UK is difficult – Lynch was referring to the much broader US market, where Dividend Achievers with long growth records are easier to come by. But that’s not to say that promising dividend records can’t be found.

At Stockopedia, we track a strategy that adopts this dividend growth approach. It targets companies with dividends that have been growing for at least five years. But there’s more to it. The companies also need to have…

  • Grown their earnings per share (EPS) by at least 10% compounded over the previous five years.
  • Debt levels that are below average.
  • As a measure of liquidity, each company needs to show that it’s more than able to cover its short term liabilities with its current assets.

The quarterly-refreshed portfolio based on this strategy has returned 22.8% over the past year (excluding both costs and dividend payments). One of the interesting things about it right now is the number of AIM companies that pass those rules. In other words, this is not just a mid- and big-cap strategy.

Name Dividend Growth Streak DPS Growth % Yield % Rolling Stock Rank™ Sector Exchange
Bioventix 5 91.7 3.6 83 Healthcare AIM
OMG 5 53.8 2.2 75 Technology AIM
Bellway 7 40.3 4.2 99 Consumer Cyclicals LSE Main
Impax Asset Management 8 31.3 3.2 83 Financials AIM
ECO Animal Health 6 28.6 1.3 75 Healthcare AIM
Photo-Me International 6 24.6 4.1 89 Industrials LSE Main
Galliford Try 7 20.6 5.9 96 Industrials LSE Main
James Latham 7 15.6 1.9 89 Basic Materials AIM

The compromise with dividend growth stocks is that they may not always have the attractive yields that you’d expect to find in high-yield strategies. But the point is that in times of uncertainty, high yields may offer false hope and can even be a signal of future dividend cuts.

By contrast, decent dividend growth streaks in growing, conservatively managed companies arguably offer more comfort that the dividend is resilient (although that won’t always be the case).

The yields in this list range from a modest 1.3% at ECO Animal Health to a heady 5.9% at Galliford Try. The longest dividend growth streak is at the AIM-quoted private equity group Impax, which has a 3.2% yield. The strongest growth last year was seen at the AIM-quoted biotech company Bioventix, which was bolstered by a special dividend.

A consistent dividend growth record can be an important reference for income investors. It can offer a sign of dividend sustainability in businesses where management will be at pains to keep the record intact. It can also give growth company investors an insight into the confidence of a management team and whether they expect earnings to grow in the future. When things do go wrong, dividends can be cut at very short notice, so careful research is needed. But in the search for dividend safety and earnings growth, a strong track record could be a useful place to start.

The Dividend Achievers screen can be found here – and a duplicated version with more detail is here.



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