Five shares for long-term income

We first ran this screen a year ago, and what is evident from the results now compared with the results then, is that quality, long-term, high-yield plays have become a lot harder to find. In fact, in March 2012 we managed to find 10 stocks that met our screen's criteria with a five-year projected income stream equivalent to an annual yield of 5 per cent or more on a net-present-value basis (more of this later). This year, we have only been able to find half that number of stocks.

The performance of last year's screen has not been spectacular to date, but neither has it been a disaster. And it is probably not entirely fair to judge a screen that looks for stocks to buy-and-hold over five years on the basis of one year's performance. However, if anything, it is fair to say year one has been somewhat underwhelming. The total return (share price movement plus dividends paid) from the portfolio was marginally below that of that of the index from which our long-term income plays were selected (see table). The income growth was also well below the portfolio's historic average. The yield from the portfolio itself, based on dividends declared, was 4.1 per cent.

*Based on dividends declared

Source: S&P Capital IQ

As with the screen we updated and re-ran last week (see 13 ways to play a resurgent USA), defence company Chemring was a major fly in the ointment for this screen in 2012. We were sceptical about the inclusion of Chemring in last year's portfolio, commenting at the time that, "the shares may prove not to be quite as sparkling as their place in our table suggests". In the event, Chemring delivered a negative 33.4 per cent total return and cut its dividend by 35.8 per cent. Without this negative contribution the portfolio would have outperformed the index and shown far superior income growth (see table).

There are no shares making it through this year's screen that we feel as sceptical about as we did with Chemring last year. That said, two of the stocks are currently rated sell by the IC. In the case of Smith & Nephew this is a short-term trading sell based in part on seasonal trading patterns. With Mitie the concerns are more fundamental and represent qualms over the price paid for a recent acquisition as well as worries about margin pressure and falling cash generation. Nevertheless, these stocks measure up based on our screening criteria which is:

■ No dividend cuts in the past 10 years;

■ Dividend growth of 5 per cent or more in each of the last three years;

■ A compound annual dividend growth rate of 5 per cent or more over both five years and 10 years;

■ Net debt to cash profits of less than two times;

■ Forecast EPS growth;

■ Dividend growth last year must be at least half the three-year compound average growth rate - this is to allow for stocks that may be down on their luck but not completely off track;

■ Our dividend forecast at least 1.5 times covered by forecast EPS - two of the stocks that qualified for last year's screen actually failed the dividend cover test this time around. These were Domino's Pizza and GlaxoSmithKline. British American Tobacco only just scraped through on this score.

FIVE SHARES FOR LONG-TERM INCOME

Centrica (CNA)

Centrica not only boasts the highest historic yield out of all the stocks passing our screen but also promises the highest potential income generation over the next five years. The company has many attributes to recommend it to income hunters and also rates as a number of analysts' favourite utility stock. Indeed, the balance sheet is very strong compared with those of its peer group and management has a sound reputation for financial discipline. Cash generation has also been impressive and is underpinning investment in organic growth, bolt-on acquisitions and share buy-backs. The company also has a far broader spectrum of possible investment options than many of its peers given its involvement in gas production in international markets. This is considered particularly important at the moment, as the market for distributing gas in the UK is mature and competitive - Centrica has recently been suffering from customer attrition. What's more, uncertainty over the power generation policy in the UK is stifling progress in this area. Centrica recently de-emphasised investment in nuclear in a strategic review. The company also potentially stands to benefit from its innovative 20-year deal to import gas from the US, which could fuel 1.8m homes a year.

Source: S&P Capital IQ

Last IC view: Buy, 365p, 26 Mar 2013

Smith & Nephew (SN.)

Replacement knee and hip specialist Smith & Nephew hiked its 2012 full-year dividend by 50 per cent as it sought to bring down the cover ratio. And this is not the only treat analysts are expecting for shareholders. The City has long thought the group could take on more debt and potentially return cash to shareholders. Indeed, broker Numis Securities reckons the group could take on another $2.5bn. Management is expected to update investors on its capital structure at the start of May - however, Smith & Nephew has already indicated that acquisitions will be the main focus of any debt increase. Indeed, the recently revamped board has already started down the acquisition trail with the $782m purchase of Healthpoint. The move diversifies the group into the wound-care market at a time when tough economic conditions are weighing on replacement joint sales growth and margins. The improving fortunes of the US consumer could be a big positive for the group, though, and the recent strength of the dollar is a bonus and should boost reported earnings. While the shares' valuation is around the top end of the peer group based on earnings multiples, it is a different story when the strong balance sheet is taken into account. Numis calculates that its forecast enterprise-value (market capitalisation, plus debt, minus cash) to cash profit rating of 7.8 times compares with an average of 11 times for comparable UK defensive plays. A change in the capital structure could make this discrepancy starker and prompt a re-rating.

Last IC view: Trading sell, 706p, 14 Feb 2013

British American Tobacco (BATS)

Tobacco has long been a favourite sector for income investors unperturbed by ethical qualms about the industry. BAT is regarded by many as the best long-term UK sector play due to its focus on emerging markets, where smokers are trading up to its premium brands and where regulation is less of a burden. In fact, western Europe is the company's smallest market accounting for 19 per cent of volume last year. That's just as well, as volumes in western Europe dropped 4 per cent during the year contributing to an overall volume slide of 1.4 per cent. But what the group has been losing from declining volumes it has been more than making up for with price rises. Its focus on four key brands - Dunhill, Kent, Lucky Strike and Pall Mall - has also helped to buoy trading. The strategy has led to good margin growth, which should be underpinned in the medium term by a large-scale investment in new IT systems. Rising prices and profitability form the foundation for broker Panmure Gordon’s EPS growth forecasts of 10.9 per cent this year followed by 8.1 per cent for the two subsequent years. The relatively slim cover on the dividend (just over 1.5 times) means dividend growth will struggle to outpace earnings growth, suggesting the dividend growth predictions in our table may be on the optimistic side. However, the group does boast strong cash generation, which is supporting a £1.5bn share buy-back this year. Panmure also points out that the shares are rated at a discount to global consumer staple peers and a comparable rating would raise BAT's share price to 3,900p.

Last IC view: Hold, 3,438p, 28 Feb 2013

Mitie (MTO)

Outsourcing group Mitie has faced tough market conditions over recent years and there are concerns about growing pressure on profit margins. The market was also spooked by weak cash conversion in the first half, which is often regarded as an early potential warning sign of trouble for support services companies. However, management has remained positive on new business prospects and the group's order book gives it very good visibility on revenues. The dividend is also comfortably covered by earnings (see table) and the shares are valued at a noteworthy discount to rivals providing white-collar outsourcing, such as Capita. The group is also entering a new market that has the potential to be higher margin and higher growth than its existing operations, such as cleaning and pest control. It paid £111m in October for Enara, which provides people with care at home. This is considered a cost-effective way for government to deal with long-term care needs. The move is not without risks and the price paid for Enara looks fairly high. However, there could ultimately be significant strategic benefits from the move.

Last IC view: Sell, 294p, 14 Mar 2013

Croda International (CRDA)

It proved to be a testing year for Croda in 2012, particularly the third quarter, but the chemicals company finished the period in fine fettle and has begun 2013 much in the same vein. One of the headwinds Croda faced in 2012 was caused by the strength of sterling. It only makes about a twentieth of its sales in its home market and currency movements had a 2.2 per cent negative impact on sales. However, this year that situation could be set to reverse with sterling having weakened significantly recently. The company is focusing on increasing its sales in emerging markets, which currently account for about 36 per cent of revenues, and it has been investing in staff and research and development in the region. The North American market has also recently been strong. Cash generation is expected to bounce back this year following a disappointing 2012. Broker Numis believes share buy-backs could be on the cards as soon as 2014 unless Croda steps up the pace of infill acquisitions. The share rating is far from cheap, but the company is widely regarded as a quality play and has a strong reputation for driving growth by finding new market niches and developing new products. Overall, prospects currently look very encouraging.

Last IC view: Hold, 2,607p, 26 Feb 2013