Shares for income and growth

With this in mind, strategists Dylan Grice, Andrew Lapthorne and Georgios Oikonomou at investment bank Societe Generale, created the Quality Income Index (QII). The QII tracks the performance over time of shares that combine a high dividend yield with the potential to make market-beating share price returns. Of course, high dividend yields can sometimes signal potential financial distress, so SG has focused its index on companies that have robust balance sheets.

The results of SG's QII speak for themselves. Since 1990, the index has returned an average of 11.6 per cent a year – more than double the return on worldwide equities over the same period. And these outsized returns weren't achieved by taking on outsized risks. The QII has actually been considerably less volatile than global stocks as a whole. In fact, it has a maximum drawdown of only 33 per cent, making it lower than for equities in general (48.9 per cent) and only slightly higher than for high-yield bonds (30.5 per cent).

The performance of the QII has been even better since the turn of the millennium: while equities in the developed world have actually been negative over the period, the QII has almost tripled.

In a similar vein, Robert Arnott, a top US money manager, made a fascinating discovery back in 2003. His research found that companies that paid out more of their earnings as dividends actually went on to achieve faster earnings growth. His evidence flew in the face of conventional financial theory. The textbooks say that high dividend payout ratios are a feature of businesses that lack exciting growth opportunities. Such companies therefore supposedly return much of their spare cash to shareholders, rather than investing it in new projects.

So, why might companies that pay out more of their current earnings as dividends achieve higher earnings growth in the future? One possibility is that paying out a high proportion of profits as dividends forces businesses to be more disciplined. With less spare cash to play with, they can't go on reckless spending sprees, overpaying to acquire rival companies, for example. Or, it may be that managers choose to pay big dividends because they're rightly confident about the future of their business.

How to do it

Based on these insights, we decided to seek out the shares in the UK stock market that most closely match the criteria of the QII.

Since we're looking for a generous income from our shares, the first screen was for dividend yield, specifically for shares with a yield of at least 4 per cent and a maximum of 15 per cent. An excessively high yield is usually a sign of a recent or pending cut in the dividend payment.

To test for financial quality, each company's Piotroski's F-score was checked. The F-score scores a company's financial strength according to nine criteria. These cover profitability, gearing, leverage, liquidity, sources of funding and capital efficiency. The higher a company's Piotroski score - ie the closer it is to nine - the better.

One alteration to SG's QII criteria concerns the size of companies surveyed. Whereas SG looked for companies with a market capitalisation of at least $3bn (£1.95bn), this screen allowed companies with a value of £800m upwards.

Finally, the shares of companies that are at the highest risk of financial distress were weeded out using Altman's Z-score, one of the best known ways of measuring corporate health. The Z-score examines five key metrics - including a company's total current liabilities, its earnings before interest and tax (Ebit) and its book value of equity. In this screen, a share had to have a score of at least 1.8 in order to make the grade. Because financial companies cannot be measured by Z-score, they are excluded entirely.

OUR PORTFOLIO

In the table below, we list the 12 companies that met all of the criteria discussed above. Of these, we have selected the top 10 to serve as our portfolio. In order to rank the qualifying shares, we awarded each one a score out of 10 on each of the criteria, giving the total score shown in the table below, leaving out the market cap as a factor, considering it more of a benchmark requirement rather than a quality or risk criteria.

GlaxoSmithKline (GSK)

Glaxo recently came down with something nasty: a $3bn fine for bribing US doctors to push its products. And the drugs giant has recently had to pay an increased price in order to take over Human Genome Sciences (HGS). Like other pharmaceutical giants, Glaxo needs to come up with new products to replace those upon which patents are expiring and HGS is part of that strategy. For all its difficulties, though, the industry is resilient to economic downturns and the share offers a healthy dividend yield of 4.9 per cent.

TalkTalk Telecom (TALK)

Talktalk has begun to shed its unfortunate reputation for poor customer service. The telecoms company's attempts to brush up its act resulted in complaint calls falling by more than one-third. It also won more than 77,000 new users over the past year. A recently launched television-on-demand service gives TalkTalk an additional source of future growth. What's more, management has promised to raise the dividend payout by 15 per cent over the next year.

British American Tobacco (BATS)

While smoking is a dying habit around much of the developed world, BAT's tobacco empire has not yet run out of puff. The maker of Benson & Hedges and Lucky Strike cigarettes has seen its share price almost double over the past five years. And while governments across the world attempt to crimp the tobacco industry's ability to advertise and market its products, the likes of BAT have helped to make up for this by winning new customers in the emerging markets of Asia, Africa and Latin America. The share registered an F-score of nine and a very robust Z-score of 3.4.

Britvic (BVIC)

Selling kids' soft drinks in unsafe packaging has been a public-relations nightmare for Britvic. The ensuing recall is set to cost the beverages maker between £1m and £5m in pre-tax profits in the current financial year - but could cost it much more in terms of customer goodwill. Some investors have been fretting that the maker of Tango and Robinson's might have to squash its dividend payment for this year, a suggestion denied by management. That's reassuring as the shares' juicy dividend is one of the key attractions here.

Micro Focus International (MCRO)

Micro Focus International's business has suffered more than its fair share of viruses and crashes in recent years. However, the company - which brings old computer systems up to date and carries out software testing – has recently said that it has turned the corner. It has also shown good commitment to delivering shareholder value, having spent substantially on share buybacks last year. Admittedly, that pushed up its net debt eightfold to £113m. It has a high Altman Z-Score of just over three.

Balfour Beatty (BBY)

Balfour Beatty's involvement in a variety of sectors including construction, engineering, military housing and investment services has proved profitable as it was able to generate new revenue streams to offset those areas that were lagging behind at the beginning of the year, notably the UK's construction market. Back in March, Balfour Beatty secured a £230m housing project for military homes in California. And it has just signed two new contracts in the past month, one in Hong Kong and one in the UK. What's more, Balfour Beatty's finances look to be in good health with net cash of £340m.

Berendsen (BRSN)

Unemployment is rising across Europe and that hurts demand for the welders' overalls, chefs' aprons and doctors' coats that Berendsen supplies. Still, the company is still winning business in the UK, as companies seek to cut costs by outsourcing. It has also gained a new contract to provide uniforms to the Berlin Fire Brigade. The City reckons that it will achieve further growth this year courtesy of its washroom and mat division, and perhaps via takeover deals. The company holds one of the highest F-Scores in our portfolio, scoring a full nine out of nine.

Mitie (MTO)

The austerity era's emphasis on cost-cutting is a boon for Mitie. As both public and private sectors seek efficiency savings, they often outsource work to Mitie, including functions such as catering, security and cleaning. And while profit margins at many businesses are feeling the pinch, Mitie's have actually expanded lately. The company's positive outlook is reflected in its bulging order book worth £8.6bn, which is up by 26 per cent since this time last year. And its Z-Score is one of the best in our portfolio.

Mondi (MNDI)

There are too many paper factories around the world, and this overcapacity makes the industry an unforgiving place to operate. In response to this, Mondi is trying to focus more on consumer packaging, which offers better growth prospects. Following the recently announced purchase of a German packaging company, it is set to earn some 13 per cent of its revenues from consumer packaging, more than double the level in 2011. What's more, it looks set to survive any sudden market downturn backed by a strong F-Score of eight out of nine and one of the top five Z-Scores in our portfolio.

Informa (INF)

Economic downturns often hit the media industry especially hard, given its heavy reliance on advertising. Informa has continued to produce a solid performance, however, thanks partly to its exposure to emerging markets. Its 'Arab Health' event has been an especial success, with bookings already stacking up for 2013. Still, Informa's shares are particularly sensitive to moves in the wider stock market, with a beta of more than 1.6. However, its dividend yield of 4.9 per cent is one of the best of our bunch here.

The Qii candidates