Prime Minister Theresa May has warned of ‘bumps in the road’ for the economy as she prepares to start the difficult journey for the UK leaving the European Union. As such, the Bank of England may need to cut interest rates to avert a downturn.

That situation would be awful for savers who are already getting next to nothing on cash deposited in the bank or building society. Thankfully, stocks and shares are among the few ways in which you can still generate a decent income.

We plan to look at the different options for generating an income from the markets over the coming months. Our series begins with dividends paid by individual companies.

Our top picks include tobacco firm Imperial Brands (IMB), utility National Grid (NG.), high street fashion outfit Supergroup (SGP) and corporate energy provider Yu Group (YU.:AIM).

Crowded trade

Income is a crowded trade as a result of the low yields available on cash and bonds. Masses of people have piled into classic dividend-paying stocks, arguably making many of them overvalued.

Blake Hutchins, who manages investment fund Investec UK Equity Income (GB00BV9G3J1), explains the need to be realistic about the level of yield you target.

‘It is important for investors to remember where we are in the equity cycle. You might have to accept a lower starting dividend yield than you had to accept three or five years ago.’

So what is a ‘realistic yield’ these days? Investec’s Hutchins says his marker is a 3% yield backed by a free cash flow yield of 5%. ‘Stretching to a dividend yield of 4% or more probably means sacrificing dividend growth or moving considerably up the risk spectrum,’ he adds.

That may sound disappointing if you’re used to the 5% to 6% that’s been available on many shares over the past decade.

Higher yields these days – such as 5% or more – could be the result of a falling share price. The market is warning that something is up with the quality of earnings, which in time could feed through to reduced dividend payments.

A useful litmus test for dividend safety is to see how many times it is covered by forecast earnings. We prefer a ratio of two or more. A
figure below 1.2 could suggest the dividend is in danger territory.

The accompanying table shows the highest yielding FTSE 350 stocks which have increased their dividend in each of the past 10 years. All have yields of 4% or more. Unfortunately you cannot presume all the companies will grow their dividend forever.

Outsourcer Capita (CPI) served up a shock profit warning on 29 September 2016 which has prompted concern a rights issue may be required to shore up its balance sheet – and potentially at the cost of its dividend.

Aerospace and defence business Cobham (COB) has already launched a rescue rights issue in 2016, while academic publisher Pearson (PSON) continues to contend with structural issues in its core US higher education market.

As such, it is important to undertake thorough research on every single company that hits your radar as a potential source of dividends for your portfolio.

Growth focus

Hutchins’ strategy is to focus on sustainable dividend growth rather than obsess over the starting yield.

Consistent dividend growth is typically a hallmark of a high quality company with the ability to generate plenty of cash flow.

And if you are in a position to reinvest the income from your holdings in dividend growth stocks, rather than taking the cash straight away, you can in theory benefit by steadily increasing your exposure to an income stream which itself is already growing.

‘When we are looking for companies with the ability to grow their dividends we are looking for two or three things. Chief among them are asset-light companies which do not require huge amounts of investment to grow,’ Hutchins says. For example, this might be a software or consumer staples business that typically doesn’t consume too much capital when it grows.’ In comparison, an oil company has to drill for oil to achieve growth, which is a very expensive exercise.

Oil producer Royal Dutch Shell (RDSB) is a popular choice for income investors. It hasn’t been able to fund dividends out of organic cash flow for some time, instead having to allow its balance sheet to take the strain.

We think the company’s plan to fix this problem by adjusting to lower oil prices will ultimately be successful before it is forced to consider its first dividend cut in more than 70 years. Nevertheless, paying a dividend out of debt is unsustainable in the long-term.

Is income expensive?

The majority of Hutchins’ portfolio is invested in quality companies like spirits maker Diageo (DGE), consumer goods giants Reckitt Benckiser (RB.)
and Unilever (ULVR) as well as software business Sage (SGE).

He rejects the argument that these so-called ‘bond proxies’, stocks offering reliable income which have attracted investment in a world of plummeting bond yields, are overvalued. He argues they are instead ‘fairly valued’.

This is backed up by recently published research from investment bank UBS which concludes income stocks ‘are not very expensive compared to history on a price to book basis in most regions’.

UBS flags 11 high quality dividend paying stocks, four of which are London-listed. These are insurer Admiral (ADM), pharmaceutical AstraZeneca (AZN), kitchen and joinery supplier Howden Joinery (HWDN) and water utility Pennon (PNN). (TS)

THE BANKS

Banks were historically seen as one of the best sources of income on the stock market. Shareholders used to get 7%+ dividend yield from Lloyds Banking Group (LLOY), for example.

The financial crash in 2008/2009 put an end to the generous cash rewards from the banking sector as financial companies had to rebuild their businesses.

Eight years on, Lloyds is approaching high yield territory once more. Investors buying shares at the current price of 55.19p could get 6.9% dividend yield over the bank’s next financial year if earnings and dividend forecasts prove correct.

Anyone who needs to rely on income from shares, funds and bonds to support their lifestyle – such as pay the bills during retirement – should not buy Lloyds, in our opinion.

There is large difference in the risks attached to Lloyds versus something that less exciting that might only pay 3% yield, such as Cineworld (CINE).

Let’s round Lloyds’ prospective dividend up to 7%. For an extra 4% yield versus Cineworld, you get to own a business that operates in an industry hampered by fines, ever-changing regulation, clunky legacy systems and whose earnings could be hard hit if interest rates fall further and economic conditions deteriorate.

The extra 4% yield from Lloyds does not compensate for the significantly greater risks versus owning Cineworld.

Cinema operators have historically done well in both good and bad economic conditions. It is an affordable treat and going to the flicks is a welcome two-hour distraction from the stress of life.

Cineworld’s dividend has increased by 10.8% compound annual growth rate over the past seven years, according to our calculations using SharePad data. You should sleep comfortably owning Cineworld shares, but Lloyds could give you nightmares. (DC)

Imperial Brands (IMB) £39.31

Dividend yield: 3.9% 

A modest retreat in the share price of Imperial Brands (IMB) following tobacco duty increases in Russia and industry-wide legal action on packaging in the US represents a buying opportunity at the tobacco giant; a consistently reliable income play.

Government duties on tobacco and packaging initiatives have long been a feature of the tobacco market and while recent developments could trim industry growth rates in the markets affected short term, Imperial’s overall prospects look good.

Results at Imperial near-term are potentially supported by read-across from its peers. British American Tobacco (BATS) and, more recently, Philip Morris International (PMO:NYSE) give valuable insight into the state of tobacco markets.

Western Europe, Imperial’s largest market, was British American Tobacco is fastest growing geography in the first half of the year. Philip Morris International, supplier of Marlboro products in markets outside the US2, also reported improved performance.

Developed Europe contributes almost one-third of Imperial’s total volume, versus just 11.2% at BAT and 17.4% at Philip Morris.

Risks include general litigation and regulation, including potential new US and EU packaging rules and the excise increase in Russia. Around 20% of Imperial’s sales volume is in the US and 9% in Russia.

Imperial, like its peers, carries a lot of debt with £11.2 billion of net borrowings versus 2016 forecast operating profit of £3.4 billion. (WC)
Disclosure: The author of this part of the article owns shares in British American Tobacco.

National Grid (NG.) £10.43

Dividend yield: 4.1%

National Grid is the owner and operator of gas and electricity infrastructure on both sides of the Atlantic. It receives a regulated price for maintaining these assets and connecting households and businesses to the network.

In addition to funding its day-to-day operations, the company has enough cash flow to pay interest on its borrowings, any tax owed and fund a generous dividend. Although the current yield is lower than the historical average, it still looks attractive given the level of visibility it offers.

The business is not at the whim of changes in the market price of electricity and gas. It makes money instead by charging gas and electricity providers for access to its network.

This network has been expanded using cheap debt and this has boosted profitability, supporting the rising dividend.

Plans to divest its UK gas distribution unit, with an £11 billion deal expected to complete in the near-term, could see shareholders benefit from a one-off capital return and would increase the bias towards the faster growing electricity network.

On the flipside there is a modest risk the resulting reduction in cash flow could pressure the dividend, despite management’s ongoing commitment to increase it by at least the level of retail price index (RPI) inflation. (TS)

SuperGroup (SGP) £15.13

Dividend yield: 1.8%

Superdry fashion brand-owner SuperGroup (SGP) started paying dividends earlier this year and is well positioned to reward shareholders with a steady stream of progressive payouts in the future.

Earnings are growing rapidly, driven by global expansion through e-commerce and an expanding store footprint across Europe. Also making early forays into the US and China, the premium quality clothing purveyor’s profitable growth looks sustainable. It is underpinned by a broadening assortment that includes womenswear, a Superdry Sport range and a well-received, headline-hogging premium Idris Elba range.

Full year results (14 Jul) revealed 16.3% growth in pre-tax profit to £73.5m on sales up 21.3% to £590.1m. Income seekers will note that on top of a maiden full year dividend of 23.2p, SuperGroup declared a first special dividend of 20p, underscoring the potential for progressive cash returns.

Cash generated from operations rose from £50.8m to £91.6m in the period, fattening the year-end net cash pile up almost 30% to £100.7m. Investment bank Berenberg forecasts growth in the ordinary dividend to 27.4p this year, a shareholder reward covered a reassuring three times by estimated earnings of 82.2p. (JC)

Yu Group (YU.AIM) 292.5p 

Dividend yield: 1%

Energy for businesses supplier Yu Group (YU.:AIM) is an attractive option for investors with a medium to longer-term investment horizon. The income credentials may not initially appear great, but this should be a rapid dividend growth story.

Analysts anticipate fast growth in the payout, presuming it continues to execute the rapid revenue gains already demonstrated this year. It has crossed the monthly losses to free cash flow generation threshold that imply its first ever pre-tax profit this year to 31 December, albeit a modest £0.1m. That is expected to expand to £2.3m, £4.7m and £6.8m over the next three years respectively.

Providing electricity and gas to UK businesses is a multi-billion pound market and a huge growth opportunity for Yu, one where organisations are still tied in to fixed-term contracts. This is unlike the consumer space where customers can switch supplier at the drop of a hat.

It joined the stock market on 17 March 2016 at 185p and the shares have since soared, peaking at 310p in September. It’s the type of business that could, perhaps should, be paying out 40% or 50% of its earnings once it matures a bit. That would imply a payout in excess of 13p per share for full year 2019, compared to Shore Capital’s 8.25p forecast. (SFr)

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