The cost-of-living crisis, job insecurity and uncertain economic conditions mean people are eager to find investments that pay a dependable stream of income.

The aim is to find something that can deliver sustained growth in the dividend each year and for the capital value to also grow over time.

GOLDEN RULE #1

There are three golden rules to follow when searching for quality sources of income. The first is not to become fixated on finding the highest yield possible. Often companies cannot sustain high dividends and cut their pay-out, which in turn can drive down the share price as the stock becomes less attractive to income investors.

It can be better to invest in a company with a lower dividend yield that grows the pay-out rather than one that struggles to pay a generous stream of income.

Ian Mortimer pays close attention to dividend sustainability when picking stocks for the Guinness Global Equity Income Fund (BVYPP13). He looks for quality factors such as a strong balance sheet and robust cash flow.

‘We believe that as we navigate the more uncertain economic environment we are currently in, having robust businesses with persistent cash generation underlying the dividend income an investor receives is more important than ever.’

GOLDEN RULE #2

The second golden rule is to consider that returns from an investment come from more than just dividends. Ideally you also want your capital to grow in value.

Ben Peters, manager of Evenlode Global Income Fund (BF1QNC4), says: ‘Investors shouldn’t just look at the yield of the company when they are making their investment decision but look at the company’s growth potential to give them an income and assess whether the business is a stable one.’

That might explain why the Evenlode fund does not invest in banks or energy companies – while they have high dividend yields, they also have unpredictable earnings so it is impossible to call them quality sources of income. Instead, Evenlode invests in companies from the healthcare, technology, business-to-business media, branded consumer goods, medical equipment and services and pharmaceutical sectors.

GOLDEN RULE #3

The third golden rule for establishing a quality stream of income from your portfolio is diversify your holdings across sectors and geographies. For example, while countries in the West such as the UK and US are experiencing higher interest rates which makes it more expensive for companies to borrow money, rates remain extremely low in Japan. Having a blend of sectors and geographies helps to spread risks.

The FTSE 100 index of UK companies has a reputation of paying decent dividends, currently yielding 3.9%. However, it is not the only source of generous income, with regions like Asia seen as attractive alternatives.

For example, Murray International Trust (MYI) generates income for its shareholders via investing in various parts of the world including just over a quarter of its assets in Asia Pacific and a further 13% from Latin America and emerging markets. It invests in both equities and bonds.

‘Diversification is important, as data from Abrdn show that over the last decade, the highest market annual returns (in sterling terms) have come from a variety of regions: the United States (five years), which until 2022 had benefited from the strong performance of its major technology companies, Latin America (three years), and Japan and Asia Pacific ex-Japan (one year each),’ says Mel Jenner, director of investment trusts at research group Edison.

‘Murray’s managers seek high-quality, cash-generative businesses, with high returns and above-average dividend yields, which can grow regardless of the economic environment. As quality companies are often fully priced, the managers look for mispriced assets.

‘The managers are confident that Murray’s portfolio of high-quality assets has the potential to perform relatively well in an environment of higher interest rates and anticipated lower equity returns.’

Three golden rules for finding quality income

1. Don’t be fixated by finding the highest yield possible

2. Consider total return (capital gains and dividends), not just yield when making an investment decision

3. Diversify by sector and geography

WHY QUALITY MATTERS

Market conditions remain unpredictable which is why it can pay to put money into investments that have high quality characteristics.

Mortimer at Guinness says high-quality dividend paying stocks can offer useful defensiveness in volatile times. ‘Quality income stocks have persistently high profitability, strong balance sheets, robust competitive advantages and, in certain cases, attractive valuations. As a result, they should offer relative safety compared to companies with greater inflation and interest rate risk such as companies with little pricing power, growth stocks with extreme valuations, and companies with high debt levels.

‘Quality companies could prove able to escape the worst of the downward earnings revisions currently seen in the broader market. Inflation has proved stickier than expected, and companies able to effectively pass on price increases, manage costs, or that are in industries less levered to the economic cycle should provide steadier, if moderate, earnings growth potential. This should be rewarded in any period where relative returns are trending lower,’ Mortimer concludes.

FUND OPTIONS FOR INVESTORS

There are ways to obtain exposure to quality sources of income through funds. Products relevant to the theme including Trojan Global Income (BD82KQ4) which looks for stocks displaying high returns on invested capital with durable competitive advantages. Names in its portfolio include drinks and snacks group PepsiCo (PEP:NASDAQ) which has grown its dividend every year since 1965. The fund yields 3.2%, has a 0.89% ongoing charge and has achieved 55% total return over the past five years.

Evenlode Global Income has 45% of its portfolio invested in companies listed in mainland Europe. A further third are in North America and a fifth in the UK. Over the past five years it has delivered a 70% total return. ‘Our holdings produce sustainable income and dividends to cope with economic volatility,’ says fund manager Ben Peters. The historic yield is 2% and the ongoing charge is 0.84%.

Guinness Global Equity Income has a bigger bias towards US-listed stocks, representing 60% of its portfolio, with the rest spread across Europe, Taiwan and Australia. It has a 2.3% historic yield and over the past five years has achieved a 77% total return. The ongoing charge is 0.79%.

Murray International yields 4.1% and has a 0.52% ongoing charge. Holdings include pharmaceuticals group Abbvie (ABBV:NYSE) and cigarette maker Philip Morris (PM:NYSE). It has achieved 43% total return over the past five years.

If you do not want to pay a fund manager to run a portfolio, there are a tracker funds on the London Stock Exchange which play to the quality income theme.

For example, Fidelity Global Quality Income ETF (FGQD) tracks the performance of an index of the same name. It has a 2.7% yield and 0.4% ongoing charge. The portfolio currently includes Apple (AAPL:NASDAQ), Nvidia (NVDA:NASDAQ) and Procter & Gamble (PG:NYSE). It has achieved 71% total return over the past five years.

To qualify for the Fidelity index, companies must pay dividends and they must tick the box for three quality criteria. The screening exercise establishes whether a company is efficient at converting sales to cash, its profitability from capital invested in the business, and its ability to generate positive free cash flow. For banking stocks, the screen looks at return on equity and debt to assets.

STOCK OPTIONS FOR INVESTORS

Investors who prefer to own individual shares can look at the holdings of the aforementioned funds as part of their research, or they might want to use one of the stock screening services available online.

Stockopedia has a ‘Quality Income’ screen on its website. This is based on a dividend strategy that focuses on companies with strong fundamentals and higher yields. It uses checklists to identify strong financial health, low bankruptcy risk and high – but not excessive – yields. Eighteen stocks currently meet the criteria including mining group Glencore (GLEN), housebuilder Barratt Developments (BDEV) and packaging group Smurfit Kappa (SKG).

Investors might argue these stocks do not meet the quality criteria given they have unpredictable or cyclical earnings – this stresses the importance of understanding any pre-set screening filters or even what a fund is looking for.

Another screen on Stockopedia’s site is ‘Winning Growth & Income’ which looks for companies with a high yield, an above-average return on equity, a below-average price to earnings ratio and where analysts have been upgrading their earnings forecasts. It also looks for companies whose share price has been less sensitive to movements in the market.

Thirteen companies pass the test including trading platform Plus500 (PLUS) and property and casualty insurer FBD (FBH).

If you want to do your own research on a stock-by-stock basis, it is important to dig deep into a company’s financials and returns profile.

While investors often check to see the number of times earnings per share will cover the dividend per share – known as dividend cover – it can be better to look at the ratio of free cash flow to dividends.

This is the amount of cash generated from operations minus money needed to keep the business going. Ideally, we want to see at least twice as much free cash flow coming in as dividends going out.

It is also good to look at operating profit margins – a double-digit margin implies a company has money to reinvest in its business, fund debt repayments, pay dividends and/or buy back shares.

Disclaimer: Daniel Coatsworth, who edited this article, has a personal investment in Evenlode Income.

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