A quick scan through the Investors’ Chronicle archives confirms it: Algy Hall was not particularly fond of dividends. Time and again, this magazine’s former stock screen steward questioned the emphasis investors place on pay-outs, wondering why they loomed so large in stock pickers’ decision making.
Algy’s main argument was that shareholders have a habit of misperceiving dividends – as a management duty, a freebie, or a means to an end – when they should instead think of them from a business owner’s perspective. From that viewpoint, dividends are one of several potential uses for spare cash, such as cutting debt, funding research and development or investing in capital projects.
A company that chooses to pay a dividend is making a simple, but somewhat inconsequential capital allocation decision to shift cash from one bank account (its own) to another (the investor’s). This also suggests it could think of no better way to spend the money.
For a while, I have shared Algy’s view, and that of the fund manager Terry Smith, who once observed that the allure of dividends “often seems to lead investors to abandon common sense or be encouraged to do so by the investment industry”.
But recently, to try and better understand dividends’ attraction, I’ve come to question some of these assumptions.
For a start, the regularity of dividends means something beyond the amount paid. Though I’ve never personally invested in stocks for their distributions, I receive a salary and value the knowledge that cash will enter my bank account every few weeks. Such reliability breeds familiarity and regular bumps of security, which is imperative to staying invested over the long haul.
What’s more, the alternative to dividend investing – to sell down stakes whenever cash is needed – is sometimes easier said than done.
In April 2020, at a time when even the most dependable income stocks were slashing distributions, many shareholders in Shell (SHEL) were looking forward to the payment of a first quarter dividend. But faced with a sinking oil price and Covid-ravaged economic outlook, management cut the quarterly pay-out by two-thirds, the first time it had done so since the second world war.
This helped push the shares below £10, a multi-decade low. The prospect of selling shares to cover the lost income wouldn’t have been welcome, which underlines the point that there are sometimes moments when an investor’s needs conflict with a business owner outlook. Plus, it isn’t always desirable to weigh up capital allocation decisions: regular dividends normally take care of this.
To my mind, however, the strongest defence of dividends is its use as a proxy for capital discipline. If there are better uses for capital than dividends, a company should communicate this clearly over time. But dividends are often also a strong signal that cash generation is very much in focus.
“It’s about what balance sheet strength you have, what level of investment you need to secure a sustainable, attractive future, and what you need to reward your investors with [for them] to be part of that journey," Schroders’ head of UK equities’ Sue Noffke told me on a panel on income investing last month. “The discipline of constantly maintained or increased dividends applies to companies as much as it does investment companies.”
This discipline, in a nutshell, is what our Safe Yield stock screen aims to do. By selecting reliable and well-covered dividend-payers, the hope is that it can identify a certain type of quality business, which may be underappreciated because it is perceived as dull.
|Name||TIDM||Total return (27 Jul 2020 - 13 Jul 2022)|
|Sirius Real Estate||SRE||-23.5|
|FTSE All Share||-||1.6|
|Source: Refinitiv Datastream|
Last year’s group of 11 stocks was a case in point. Despite underperforming its benchmark, the cohort included two companies – Stock Spirits and Ultra Electronics (ULE) – which were targeted by acquirers, and whose subsequent share price rises helped to offset most negative returns elsewhere. In the scheme of things, that’s not a bad record, and suggests the screen’s criteria aren’t wildly out of line with the kind of due diligence corporate buyers undertake.
Since we started running the screen 11 years ago it has clocked up a cumulative total return of 190 per cent, compared with 90 per cent from the FTSE All-Share. Although it has fallen in value over the past year, it has kept up its habit of outperforming most of the value-based screens we track in these pages – which is an interesting phenomenon, given higher yields tend to indicate a value stock.
While the screens run in this column are meant as a source of ideas rather than off-the-shelf portfolios, if we add in a 1.5 per cent charge to account for notional dealing costs, the return drops to 146 per cent.
The exceptional circumstances of the past three years created a couple of problems. I’ve stuck with a couple of small amendments to the criteria made last time round to try to account for the fact that some otherwise reliable companies will have experienced nasty one-off hits due to the pandemic. To boost results I’ve allowed shares that fail one test to qualify as long as they have passed the dividend yield, dividend cover and beta tests. Three stocks passed all the tests, while details of the test failed by the remaining seven are given in the accompanying table. The full screening criteria are:
■ Historic dividend yield of at least 2 per cent or next-12-month forecast yield of over 3 per cent (a bit above the median for dividend-paying FTSE All-Share constituents in both cases).
■ Dividend cover of at least two times – historical or forecast.
■ Interest cover of at least five times.
■ Dividend growth over the past three years.
■ Forecast earnings growth in each of the next two financial years.
■ An average return on equity over the past three years of at least 12.5 per cent.
■ Cash conversion (measured as cash from operations to Ebitda) of over 90 per cent.
■ A market capitalisation of at least £250m.
■ Beta of 0.75 or less.
This year, 11 stocks in the All-Share met the above criteria, and the results are included in the table below. A downloadable version of the screen results table, with plenty more data points, can also be found here:
|TEST FAILED||Name||TIDM||Mkt cap||Net cash/ debt (-)*||Price||Fwd PE (+12mths)||Fwd DY (+12-mths)||FCF yld (+12-mths)||Net debt/Ebitda||Op cash/ Ebitda||Ebit margin||ROCE||5-yr Sales CAGR||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth mom||3-mth Fwd EPS chng|
|-||BAE Systems||BA||£25,162m||-£3,245m||797p||15||3.4%||5.8%||1.3 x||96%||9.6%||14.9%||1.9%||8%||7%||4.1%||4.4%|
|-||Hikma Pharmaceuticals||HIK||£3,662m||-£292m||1,664p||10||2.8%||3.5%||0.5 x||97%||23.4%||18.6%||5.1%||13%||11%||-19.6%||3.4%|
|-||LXI Reit||LXI||£2,479m||-£180m||145p||17||4.4%||-||3.6 x||94%||-||4.0%||-||17%||7%||-3.6%||6.9%|
|Divi Grth||UK Commercial Property Reit||UKCM||£951m||-£206m||73p||22||4.2%||-||4.9 x||91%||-||2.9%||-1.4%||15%||7%||-21.6%||8.9%|
|Cash Conv||MJ Gleeson||GLE||£300m||£38m||514p||7||3.8%||2.0%||-||70%||14.6%||16.2%||15.2%||4%||5%||-19.7%||3.0%|
|Cash Conv||Spirent Communications||SPT||£1,499m||£107m||245p||16||2.7%||-||-||81%||19.0%||22.8%||4.3%||12%||9%||5.5%||14.2%|
|Cash Conv||Coats||COA||£912m||-£182m||63p||9||3.2%||9.1%||1.0 x||74%||13.0%||25.5%||0.2%||24%||13%||-12.9%||17.6%|
|Divi Grth||Custodian REIT||CREI||£442m||-£125m||100p||15||6.0%||-||4.2 x||108%||-||5.0%||7.5%||7%||2%||-1.8%||1.5%|
|Int Cov||Vivo Energy||VVO||£1,931m||-£150m||152p||13||3.6%||-||0.5 x||124%||3.5%||18.1%||7.7%||18%||3%||9.8%||-|
|Cash Conv||Dr. Martens||DOCS||£2,427m||-£166m||243p||12||2.6%||6.2%||0.6 x||69%||24.9%||36.5%||-||9%||12%||3.5%||6.2%|