Time to question our dividend-based stock screen

Although this feels like an intelligent way to approach stockpicking, there is something slightly odd about its name and methodology. For a start, what do we mean by a safe yield? While this is a question many investors think about, it requires some unpacking. Even then, it isn’t always clear-cut.

In the world of fixed income, yields are usually very safe. Unless a country or company defaults on their obligation to meet coupon payments, a bond’s yield can be considered locked in until maturity. And because defaults are mercifully rare, the balance of risks equates to safety.

Then again, it’s debatable whether a yield can be called safe if its returns are eroded by inflation.

For example, in a six-month window in 2020 the UK government sold a £34bn slug of ordinary bonds with a redemption date of January 2023, and paying an annual coupon of 0.125 per cent.

Assuming you bought in at par (such was the madness of 2020 that buyers of later tranches chose to lock in negative yields) and held to maturity, you would have received a safe yield. That is, you would have been paid the promised interest, on time and in full. You would have also lost just under a fifth of your capital outlay in real terms after swallowing the biggest spike in inflation in decades.

For an investor trying to preserve their wealth, the value of money has been a bigger consideration than yield safety over the past two years.

This helps explain why the UK is on course to run up the highest debt interest costs in the developed world this year. Inflation-linked gilts, whose interest payments rise with prices and which make up around a quarter of UK government debt, have understandably proven a hit with bond buyers trying to minimise real-terms portfolio losses.

Do equities offer safer yields? If history is a guide, then company earnings tend to grow over time, thereby increasing a share’s earnings yield. Earnings growth is also a rough proxy for dividend growth, meaning ‘yield’ as it is commonly defined tends to be safe, although not always. According to the latest UK Dividend Monitor report, UK-listed firms are on course to reduce their dividend payments in 2023. This would be third time the annual total has declined in a decade.

This year’s drop is likely to stem from a reduction in the level of special dividends paid out by mining and energy giants in 2022. While this doesn’t amount to a cut as such, it does show that yields are never static, and can fall and rise.

For our screen, that needn’t be a problem. In truth, its focus on dividends is a bit of a misnomer, and less about unearthing great income opportunities than finding lower volatility stocks whose dividend track record and cover are an indirect marker of underlying profitability and capital discipline. While good companies will always have lots of uses for their spare capital, this doesn’t mean they are able to generate enough spare cash to allocate capital flexibly. Our Safe Yields screen tries to correct for that.

This, I would argue, is a handy way to think about dividends in the broadest sense. Ultimately, the payment of a dividend is a cash transfer from corporate treasury to an investor bank account, and one use of spare capital alongside de-leveraging, product development, or raising wages.

So are dividends a good proxy for underlying strength? The performance of the screen’s 2022 selections provides reasons for doubt. The screen managed to pick three stocks which beat the benchmark, including the since-delisted cybersecurity group Avast, which was acquired by US peer NortonLifeLock – now GenDigitak (US:GEN) after a surprise clearance by competition authorities last September. But returns were undone by a heavy weighting to property, including three real estate investment trusts.

Strip out those Reits – Custodian (CREI), UK Commercial Property (UKCM) and LXI (LXI) – and the screen would have made a 0.5 per cent total loss for the period. As it was, the screen declined by 6.4 per cent, compared to an 8.2 per cent positive total return from the benchmark.

For property investors, yield matters. In the case of Reits, which are legally obliged to distribute 90 per cent of their taxable profits to shareholders, the income case is of primary importance.

However, dividends can be a blunt measure of quality when there are bigger questions about asset values and the ability to balance rental growth with rising interest payments. For owners of large illiquid assets like real estate, rebounding from this dynamic can be especially tricky, given the challenges of repurposing property and the need to balance rents and wavering demand without destroying invested capital.

To draw a comparison, a ‘safe yield’ in the field of water resource management involves withdrawing no more water than can be replenished by nature. Currently, there are big questions around the capacity of some commercial property funds to manage to do something similar over the long term, and whether dividend cuts could follow. Though there is some evidence that UK stock prices rise after a cut, this usually follows a sharp decline and months (or years) of souring investor sentiment, which makes it a difficult dynamic to profitably navigate.

Since we started running the Safe Yields screen in 2011 it has clocked up a cumulative total return of 171 per cent, compared with 106 per cent from the FTSE All-Share. While the screens in these pages 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 a more pedestrian 126 per cent. 

In keeping with the last couple of years, I’ve stuck with a couple of small amendments to the criteria to try to account for the one-off Covid-19 hits experienced by otherwise reliable companies. In the interest of boosting the results, I’ve also allowed shares that fail one test so long as they have passed the dividend yield, dividend cover and beta tests. Four stocks passed every test, while details of the test failed by the remaining six 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 (which this year sits below the median of 3.1 and 4.1 per cent for dividend-paying FTSE All-Share constituents).

■ 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 £250mn.

■ Beta of 0.75 or less.

A table of this year’s 10 selections are included below. This year, no property firms, developers or industry-adjacent stocks make the cut. A downloadable version of the screen results, with plenty more data points, can also be found here/on the online version of this article.