Finding today's dividend winners

Likewise, the financial services sector looks attractive on historical measures, but these dividends are clearly unsustainable. Leading banks, notably, look like they will be forced to slash dividends as a result of their recent government-driven capital-raising. Consumer-facing groups are also highly exposed to economic volatility as households, like banks, begin a slow and painful process of de-leveraging debt. It is no surprise that our 'raw' high-yielding portfolio contains companies in all of these troublesome clusters, where recent massive share price falls flatter the dividend.

Raw Dividend Yielders

The 2008 Dividend Momentum Portfolio

Given the success of 2005's Dividend Winners portfolio (see below), I have tried to replicate the success with a new portfolio based on the principle of dividend momentum. The theory remains the same, in that we want companies where dividend growth outstrips earnings growth and is above inflation, so that returns are not eroded by natural devaluation.

Raw Dividend Momentum

First, let's take a look at the top 20 dividend growers – those companies that have grown their dividend at the fastest annualised rate over the past 10 years (see table, below). The runaway winner is accounting software specialist Sage, which has increased its dividend by an average of 43 per cent a year for the past decade. Sage emerged as a company to watch last time we ran this exercise – at the time, it offered a lowly dividend yield of 1.2 per cent, but wanted to accelerate its dividend growth to reduce its unusually high dividend cover.

Close behind is global security group G4S, which has grown its dividend by a massive 35 per cent a year since 1999, and then Capita. All are well-run FTSE 100 companies, and global leaders in their respective fields. Like Sage, Capita cropped up in our original dividend growth portfolio, and paid a below-average dividend despite solid cash flows.

Miners also occupy a prominent place in the table, with BHP Billiton and Anglo American increasing their dividend by a compound annual growth rate of 24 per cent and 21 per cent, respectively, over the past decade. In both cases, the increases have come steadily each year, and are likely to continue as mining companies are highly cash-generative. And with mining shares in the doldrums, now could be a good time to buy for long-term recovery.

10-year dividend momentum

Dividend acceleration

Less convincing are the dividend growth prospects of those companies with higher exposure to consumer expenditure that have sustained a very high dividend growth rate over the period. Pub groups such as Enterprise Inns and Wetherspoon provide particularly good examples (Wetherspoons falls just outside the list above). In both cases, if we look at the rate of dividend growth over a shorter period, it becomes clear that dividend momentum has dried up at these companies – Wetherspoons didn't increase its dividend at all last year, and has recently announced that it's cancelling the dividend altogether. Similarly, companies such as Savills and British Sky Broadcasting are highly exposed to a consumer slowdown, and that's reflected in their slowing rate of dividend growth.

So, to weed out these likely underperformers, we ran five and then two-year filters on the list, to provide both an indication of consistency and recent strength (see table below). And several of the winners from portfolio one survive the cut, notably Man Group, Sage and BHP Billiton. Property companies are also notably accelerating their levels of dividend payments, in this case British Land and West-end retail specialist Shaftesbury, although this is largely due to their recent conversion to real estate investment trust (Reit) status, which mandates that they pay out 90 per cent of distributable earnings as dividends. However, given the parlous state of the global economy, commercial property faces major challenges which means the dividend boom could be somewhat short-lived.

Dividend Acceleration (Highest growth 2 & 5 years)

The Dividend Yield Filter

Of course, we're missing something vitally important, and that's whether these companies offer an attractive dividend yield (see table, above). Companies such as Aveva and Chemring may demonstrate decent dividend growth prospects, but they don't offer a particularly attractive dividend yield. And companies may be able to demonstrate a high rate of dividend growth because they're playing catch-up, having historically paid out dividends well below their level of ability to pay (as measured by dividend cover), or grown dividends below their rate of earnings growth.

But again we have to be careful – if we add a filter that searches for companies with a dividend yield greater than 5 per cent, we start to find companies that have suffered massive share price falls that now make the dividend yield look unusually attractive – like Cattles, at 54.1 per cent (it's heavily exposed to the sub-prime credit market, but analysts are still predicting a dividend increase next year). Likewise, shares in electronics distributor Electrocomponents have struggled of late, which is why the yield looks so high, except in its case we know that it's planning to cut its dividend payment by 40 per cent from next year.

Troubled Marks and Spencer recently appeased its investors when it said that it planned to hold its dividend, but the consensus view among analysts is that it, too, could be forced to cut the payment if trading deteriorates further.

Dividend Momentum with Yield Filter

The final cut – cover and gearing

So now we need to find the companies that offer both above- average growth and above-average dividend security, and that's no small challenge in today's turbulent markets. Thankfully, we've one more filter to run that should strip out those companies (see table below).

Dividend cover has its shortcomings as a filter – as well as failing to reflect a company's future earnings prospects, it also fails to reflect whether a company's other financial liabilities will put pressure on its ability to continue paying a dividend. Because of this, we've decided to apply a gearing filter – in this case interest cover of greater than four times annual interest payments – to weed out companies with a dangerously high level of debt. This is particularly important as some companies have been borrowing cheaply to fund dividend payments. We also want companies with dividend cover better than two times.

We now have a select group of companies that pay a dividend yield better than the rates offered by high-interest savings accounts, and show above-average dividend growth on a consistent basis. Hedge fund manager Man Group makes the grade yet again – it has zero gearing and pays a well-covered dividend yield of 6.3 per cent and, although it has been battered by recent stormy stock markets, it has still managed to attract new funds.

Millennium & Copthorne Hotels has emerged, perhaps counter-intuitively, as a dividend leader – its focus on growth regions such as China and the Middle East means that its trading has remained fairly resilient to the downturn. Its shares have fallen sharply, though, and now trade well below net asset value – combined with an attractive yield that stands out as a buying opportunity. United Business Media is similarly focused on Asian markets, which helped it generate 30 per cent first-half EPS growth. Again, given troubles at other media companies such as Trinity Mirror and Johnston Press that seems counter-intuitive; however, unlike UBM, they've been hurt by exposure to local advertising markets.

And if this last example highlights one thing, it is that fundamental analysis of a company's prospects remains crucial. It's worth remembering that this is a stock-screening exercise that removes any qualitative judgment from stock-picking. The caveat is that this is more a source of ideas than an absolute guide to the best income stocks, and it's worth applying more rigorous analysis to each of the companies in question before taking the plunge.

The final cut: top 10 dividends on the move