Dividends with strong support

The support services sector has provided rich pickings for the dividend of the week in the past, so we can eliminate former dividends of the week Carillion, Smiths News and RPS Group immediately. From there, we will look at the recent dividend-paying history and look for a CADI (consecutive annual dividend increase) of greater than five, which after eliminating the aforementioned three stocks reduces our list to 15 stocks. Next, we look for solid dividend cover of greater than two, and our list is further reduced to 13.

So, our long list is: MITIE, Interserve, G4S, Diploma, WS Atkins, Bunzl, Capita, Serco, Babcock, Experian, Aggreko, Intertek and Ashtead. It is interesting to note that seven of these stocks are in the FTSE 100, which gives you some idea as to the importance of this sector.

We are going to eliminate Intertek (ITRK: 3,292p) and Ashtead (AHT: 663p) on yield grounds, as both currently have an annualised yield of under 2 per cent. Having said that, this week we are not necessarily chasing yield, but are looking for companies with excellent track records who look well set to continue with good dividend increases into the future.

MITIE (MTO: 317p), on the other hand, offers both a decent yield and a very good track record of dividend growth, with increases averaging 16 per cent between 2007 and 2011, but the past two years has seen a marked slowdown into single-digit percentages. Interserve (IRV: 632p) has a slow steady record of increases, but nothing over 7.9 per cent over the past five years. This is also the case with WS Atkins (ATK: 1,203p), Capita (CPI: 995p) and G4S (GFS: 259p), which like MITIE are all showing a slowdown in dividend growth in the past two years after a period of rapid increases.

Diploma (DPLM: 677p), though, meets our criteria, with an excellent track record of increases that runs through to the last dividend - it's forecast to increase its payment by 18 per cent this year after average dividend growth of 24 per cent in the previous six years. Bunzl (BNZL: 1,375p) also scrapes through in terms of growth, but scores highly on absolute yield and dividend cover, so survives the cut at this stage. Serco (SRP: 560p) gets through easily with a superb record since 2006, and strong fundamentals, too. Similarly, Babcock International (BAB: 1,268p), Experian (EXPN: 1,266p) and Aggreko (AGK: 1,602p) all continue to deliver increases well into double digits.

So our short list is quite long, but a good look at the fundamentals will hopefully point us in the direction of better value - hard to find in markets which continue to surge.

The average forward price earnings ratio for the support services sector as a whole is 16 times, which is roughly in line with the wider market. The sector has enjoyed an upwards re-rating of late with the forward price-earnings ratio moving up from around 14 times this time a year ago. And most of the names on our short list trade at a premium to the sector average, so can hardly be called 'cheap'.

At this stage, we are going to seek help from the brokers to see if we can get our shortlist down to three. The table below represents the number of brokers giving each recommendation:

In spite of what the brokers think, Experian looks too expensive on a forecast PE ratio of 21 times earnings and yielding barely above 2 per cent. Forecast earnings growth over the next two years is 10 per cent, not enough to justify the rating - and could hold back dividend growth.

Serco, however, looks good enough value to warrant further investigation. The company trades on a forward PE ratio of just 12.9 times, which represents an 18 per cent discount to the support services sector average. As is usually the case, there is a reason for the discount - Serco has suffered reputational damage having been accused of overcharging on government electronic tagging contracts and lost its chief executive just last week.

Aggreko, meanwhile, has just released an interim management statement which was well received by the market, and in spite of their current rebasing of the dividend cover from over four times to nearer three, they do not make the cut on valuation grounds either, trading on a forecast PE of nearly 17, and also share the wooden spoon with Bunzl as far as the brokers are concerned. We tend to agree with the brokers in the case of Aggreko - half-year earnings slipped and order intake at its important power projects division is under pressure, yet the shares remain expensively rated.

However, we disagree with the brokers on Bunzl and are happy to put them through to the short list. More brokers rate Bunzl a sell than a buy, perhaps because there are concerns that its M&A driven approach means it is buying growth. But that's a decent use of its strong cash flows - which also gives it scope to keep growing the dividend - and with the second best yield of our short list and a decent dividend growth track record, we keep it in.

This leaves Diploma and Babcock. Specialist distributor Diploma's first-half results in May revealed tough trading conditions and a drop in margins, while the company's recent update is guided towards lower margins for the full year, too, with the final results due on 18 November. The shares are trading at a premium to the sector, too. Trading conditions at defence outsourcing specialist Babcock - well into a recovery plan and tipped by Investors Chronicle last month - look brighter. The company is on track for another solid year after the recent trading update confirmed that around 80 per cent of the anticipated revenue for the current year is already contracted, and a huge bid pipeline should keep business ticking over for many years. For this reason and its lower rating we are going to go with them for the final cut.

Let's have a look at the dividends paid by each company over the past six to seven years:

Serco

n.b. 2013 interim dividend up 16.9%

Bunzl

n.b. 2013 interim dividend declared at 10p goes ex dividend on 6th November.

Babcock International

Bunzl increased its interim dividend by over 13 per cent at the half-year stage and the current consensus of analyst forecasts is expecting the full-year dividend to rise by 10 per cent, funded by solid cash generation.

Babcock has been a very impressive performer over the past five to six years and has increased its dividend by 226 per cent over the period from 2006 to 2012. It will deliver interim results on 12 November, and with current City consensus for an 8 per cent rise in the dividend over the full year, another healthy dividend should come with the results.

Serco, like Babcock, has delivered consistent dividend increases, growing its dividend by 180 per cent over the period from 2006 to 2012. A further 16.9 per cent increase at the interim stage kept that momentum up. Granted, it was demoted from the FTSE 100 in the latest reshuffle and there is a cloud hanging over it as investors await the outcome of the ongoing review into UK government contracts, but does it merit such a discount to its peer group? We think not as the company is going to great lengths to restore its reputation. Its recent update announced measures, including the splitting out of its UK central government business, strengthened corporate governance and improved transparency.

From a dividend perspective there is also much further to go and the interim results pointed to an "interim dividend increase of 17 per cent, reflecting policy of accelerated growth to move to higher payout ratio." Certainly, if the dividend cover were to move from its current 3.7 to a solid 2.5, then dividend increases of between 15 and 20 per cent can be expected for the next three years or more.

Because of its lowly rating in the sector and their unrivalled dividend growth track record, it is difficult to choose any other stock other than Serco for our dividend of the week. Sure, the group has had its fair share of recent problems, but that has offered a rare opportunity to buy the story on the cheap - the shares have fallen 17 per cent since the summer's problems. We believe that the current steps being taken, alongside the appointment of a new credible CEO, will revive Serco's fortunes and will see them promoted back to the FTSE 100 within the next two years.