Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Five dividend growth stars to buy
Dividends are an important contributor to every sensible long-term investment plan and yet they are probably underappreciated by investors, because they are sometimes perceived as dull.
They are often associated with ‘income seeking’ investors or companies which have low growth prospects.
However, that view is misleading, especially considering the role dividends play in creating shareholder value.
According to research from Ned Davis Research, from 1972 to 2019, dividend paying companies in the S&P 500 index delivered an annualised total return of 12.8% compared with 10.9% for non-dividend paying stocks. Total return accounts for capital gains/losses and dividends.
A 1.9% gap might not sound like much but compounded over 47 years it means the dividend paying shares could have returned more than double the non-paying shares.
Even better, in times of relatively scarce earnings during periods of low economic growth, the contribution from dividends to total returns is even higher. For example, in the 1940s and 1970s dividends accounted for 75% of total shareholder returns.
The calculation assumes that dividend income is used to purchase new shares and it is this compounding effect which turbocharges shareholder returns.
With investors increasingly worried about inflationary pressures, you may be surprised to learn that companies which pay dividends have historically been a good hedge against inflation.
According to data from US economist Robert Shiller, since 1940 the average growth in dividends over rolling 10-year periods has been 4% a year, double the rate of inflation as calculated by the US Bureau of Labour.
Don’t focus on yield alone
With historically low interest rates across the developed world, investors have been starved of yield. This may have led some investors down the path of searching for the highest dividend yields, irrespective of the underlying fundamentals of the business.
Data from Ned Davis Research shows that companies earning just enough to pay out dividends, implying a high payout ratio, significantly underperformed the S&P 500 from 2002 to 2020.
That’s because they tend to be companies in highly competitive industries which don’t generate enough cash to sustainably pay a dividend. Conversely, stocks with medium to low payout ratios outperformed.
There seems to be a good case for accepting lower, but potentially more sustainable income over higher, but possibly less sustainable income. Particularly as this leaves capacity for dividends to grow.
By reinvesting your dividend and using it to buy shares in the same firm you’ll be steadily increasing your holdings of that particular stock. In turn, you’ll be setting yourself up for even more dividends down the line. Your benefits are enhanced further if the actual dividend payment is also growing each year.
It should also be remembered that even a 2%-to-3% yield is very attractive relative to current risk free rates of interest.
Dividends provide useful signals to shareholders
It’s often forgotten that the decision to pay a dividend is part of management’s capital allocation policy and as such it signals a lot about a company’s ability to generate cash, its growth opportunities as well as its attitude towards shareholders.
As a reminder, firms have three choices for the cash that they generate, and they aren’t mutually exclusive. They can reinvest in the business to grow, purchase growth via acquisition or payout cash in the form of dividends or share buybacks.
Mature companies with strong market positions often generate higher than average returns on capital, which means they generate excess cash even after reinvesting for growth. These are great to own because investors potentially get growth and a progressive income.
Portfolio Managers at Guinness Global Equity Income Fund (BNGFN77), Ian Mortimer and Matthew Page, believe that committing to a dividend can act as a discipline on management and keep them from spending on ‘vanity projects or frivolous uses of capital’.
Once a dividend policy has been set and communicated to the market, management have effectively set a line in the sand and will then only cut if absolutely necessary because of economic circumstances.
It can take a long time to build the trust of shareholders so companies will be very reluctant to blow that trust by cutting the dividend.
This means they tend set the dividend payout conservatively, below the level of earnings, which gives management some flexibility to maintain the dividend even if earnings splutter from time to time.
In recent years the trend for buying back shares has become commonplace, especially in the US. From a capital allocation perspective, buybacks should only be considered if they have a good chance of increasing shareholder value.
Theoretically, if a firm buys back shares when management considers them to be undervalued, it can be one way to create shareholder value. However, assessing fundamental value is tricky and not a precise science.
Also, management greed has muddied the waters. Compensation is often contingent on earnings per share growth and buying back shares increases per share growth, everything else being equal.
Studies have shown that companies tend to buy back shares when they have the cash to do so. It often happens at the back end of economic expansion cycles, rather than when they believe their shares are cheap.
Finding sustainable dividend growers
Guided by the results of the academic studies mentioned we have created a fundamental screen to find potential dividend growers, principally using data from Stockopedia.
Essentially, we are looking for established, large businesses which have a history of steady, rather than spectacular earnings growth.
They will ideally generate higher than average returns on capital and exhibit a history of regular, progressive dividends and a solid balance sheet. We have insisted on a maximum payout ratio of 80% of earnings.
The screening criteria we used was demanding – we isolated the top 25% of firms with the highest five year returns on equity and gross profits to assets, a free cash flow to sales ratio above 12% and at an unbroken trend of dividend increases over the past nine years.
Gross profit to assets was popularised by Robert Novy-Marx of the University of Rochester and is considered a good measure of quality. His research found that companies with the highest returns outperformed those with the lowest and interestingly the ratio was more predictive than widely used earnings and cash flow valuation metrics.
The screen identified just seven names and we discuss the merits of our top five companies below.
OUR TOP 5 PICKS
Based on near-term forecasts, equipment hire business Ashtead (AHT) is not cheap and offers a modest yield marginally above 1%.
However, investors should focus on the long-term potential for dividend growth and Ashtead’s track record is exceptional on this measure. It even maintained its progressive dividend policy in the teeth of the pandemic.
Dividends have gone from 2p in 2010 to 40.65p in 2020 – that latter payment representing a yield of 35% on the price you could have purchased the shares at the beginning of that decade.
The company generates most of its earnings in the US through its Sunbelt operation and it is seen as a beneficiary of the big infrastructure spending plans outlined by the Biden administration.
High margins and substantial cash generation enable the company to both invest in the business and underpin the company’s standout dividend growth.
Since premium spirits mixer company Fevertree Drinks (FEVR:AIM) initiated a maiden dividend of 3.08p per share in April 2015, the firm has grown the payout to 15.68p per share, representing a compound average growth rate of 38% a year.
The company is highly cash generative due to its capital light business model, where it outsources capital-intensive activities such as manufacturing, enabling it to spend more resources on sales and marketing and building brand value.
There is plenty of growth potential for the company to exploit its differentiated products and expand its global footprint.
Liberum estimates that if the US premium market reaches the same penetration as the UK by 2030, Fevertree’s US revenues could increase six-fold.
There is scope for good dividend growth in line with earnings while the payout could also increase as the company matures over time, so don’t be put off by the 0.8% yield.
The electronics engineer remains one of those stock market rarities – a company that never seems to put a foot wrong. Shareholders have benefitted from this reliability for years with capital returns close to 1,000% since the end of 2009, yet Halma (HLMA) remains a company with an underappreciated income story to tell.
Typically offering a dividend yield below 1%, it is easy to see why many investors wouldn’t put much stock in Halma’s income angle. Yet the consistency of its year after year above-inflation increases (42 years above 5% to date) can make a significant difference over time.
For example, had you bought Halma shares in early 2011 at around the prevailing 350p level, you would have since earned 143.27p back in the shape of dividends, including the latest declared 10.78p payment. That works out at nearly 41% of your original capital outlay.
Halma has been increasing its dividend for years and with excellent cash generation (104% of operating profits last year) and easily manageable net debt (£256.2 million). We believe it will continue to reward investors for years to come.
Information services firm RELX (REL) has successfully managed the transition in the publishing sector from print to digital over the past decade or so and become a high-quality business.
Scientists, lawyers or people in the insurance industry subscribe to the tools and information provided by RELX as they are considered essential for doing their job.
RELX benefits from subscription-based recurring revenue which should support its ability to grow the dividend. It has achieved 9.6% compound annual growth rate in dividends since 2015, according to Stockopedia. While a yield of 2.9% may not look overly generous, the capacity for income growth is the key attraction. A price to earnings ratio for 2021 of 25.7 times isn’t overly expensive either.
The group generates 60% of its revenue from subscriptions. The rest comes from transactional activities (39%) and advertising (1%).
Where the company adds value is by taking large sets of data and distilling this into salient information which is useful for its clients.
Investment bank Berenberg notes that RELX has demonstrated its ability on an underlying basis, to deliver c4% sales growth, 6% operating profit growth and 8% earnings per share growth in recent years.
Specialist steam technology and pumps company Spirax-Sarco Engineering (SPX) has delivered an incredible 53 years of consecutive dividend growth, representing a compound annual growth rate of 11%.
The company operates in a global market worth £10 billion and yet the firm estimates it has a market share of only 12%, suggesting scope for further penetration.
Spirax’s business is highly cash generative, reflecting strong margins and visible revenues. Roughly 85% of the group’s sales are generated from its customers’ annual maintenance and repairs contracts which tend to be more resilient.
Over 55% of group revenues are derived from defensive, less cyclical end markets.
A key driver for the business is industrial production and population growth.
The company’s strong track record and solid market positioning suggests it will continue to deliver consistent growth in earnings and dividends per share.