Seven shares for reliable income

Given this backdrop, there is a real irony with the choice of name for the screen I’m running this week. I instigated the Inflation Beaters screen when the global monetary experiment in quantitative easing (QE) was still young and a popular notion was that 'free money' would cause rampant inflation. The screen sought to protect against this by targeting stocks that had a strong record for growing dividends above the rate of inflation. The screening criteria is as follows:

■ A rising dividend in each of the past 10 years.

■ 10-year and five-year compound average dividend growth of 5 per cent or more and growth in the past year of 5 per cent or more.

■ Dividend cover of two times or more.

■ Net debt of less than 2.5 times cash profits.

■ A return on equity of 15 per cent or more.

■ A dividend yield of 2 per cent or more.

■ Forecast earnings growth both this year and next.

While the feared QE-induced inflation surge never emerged (maybe it will now), these types of stocks arguably benefited from another much-talked-about trend known as 'bondification'. This is the process whereby fixed-income investors have been forced to turn to reliable dividend-paying equities to generate decent income due to the very low yields from bonds. Many view this as having propelled the performance of the kind of bond-like equities this screen targets while pushing valuations to hazardous levels. That means inflation may now actually pose a threat to this screen – so view the name on the tin with some scepticism. The graph below, reproduced from M&G’s episodeblog.com, illustrates why people see a strong connection between bond yields and the performance of bond-like equities, many of which are to be found in the consumer staples sector.

The year just gone has been good for my Inflation Beaters screen with the 15 stocks picked 12 months ago delivering a 16.8 per cent total return, compared with 10.7 per cent from the FTSE 350, which is the index the screen's results are drawn from. In the six years since I started to run the screen, the cumulative total return stands at 99.1 per cent, compared with 71.1 per cent from the index. If I factor in a 1 per cent charge to account for the notional costs of switching from one portfolio of ideas to the next at the time of publication each year, the cumulative total return from the screen drops to 87.4 per cent.

2017 Inflation Beaters performance

This year seven stocks have passed the screen’s tests. The screen’s dividend yield test sets a low bar and none of the qualifying stocks can be regarded as offering a particularly attractive level of yield, although the historic persistence and growth of payouts is impressive. I’ve taken a closer look at the two highest yielding shares and details of all the screen’s share picks are listed in the accompanying table.

Seven shares for reliable income

Source: S&P CapitalIQ

Whitbread

The performance of shares in budget hotel and coffee shop operator Whitbread (WTB) has been lacklustre over the past few years. As the hotel industry cycle has got longer in the tooth, more supply has come on to the market and Whitbread’s Premier Inn budget hotel chain has faced more competition. Meanwhile, the Costa Coffee chain, which accounts for just over a quarter of operating profits, faces challenges from the ongoing decline of the UK’s high streets. The strain has been showing up as a steady decline in like-for-like sales in the UK, with the group most recently reporting growth had slowed to a marginal 0.3 per cent during its third quarter.

What’s more, while the company has said it expects to meet full-year profit expectations, this is mainly due to cost savings coming through more quickly than expected to offset the deteriorating sales trend. That means brokers have been downgrading forecasts for the group’s 2019 and 2020 financial years.

Whitbread is attempting to remedy these issues. The group is putting more focus on expanding its hotels business overseas, with an emphasis on Germany where the branded budget hotel market is relatively undeveloped. However, with only about 3 per cent of hotel rooms located outside the UK, there is a lot to do before this represents a significant part of the business. Meanwhile at Costa, which does have a good proportion of its business in overseas markets, management is seeking to open new outlets in travel hubs which offer far better prospects than the high street. The chain also continues to roll out its lucrative Costa Express machines.

But while Whitbread’s assets and operational know-how remain impressive and its strategy makes sense, there are few ways for this consumer-facing business to dodge the headwinds it faces in the UK. Fortunately, the valuation has already adjusted some way to reflect the issues with the forward PE, based on Bloomberg data, in the bottom 10 per cent of the five-year range and the dividend yield in the top 10 per cent. On a 10-year view, which takes into account the impact of the credit crunch, the forecast PE is in the bottom 45 per cent of the range and the yield is almost in the top two-fifths. Set against any valuation attractions, though, is the fact that long-term earnings expectations are in the bottom quarter of their 10-year range.

Overall, Whitbread’s current valuation does not look bad for what has proved to be a high-quality play over the years, but it is currently hard to see evidence of the recent negative sales trend ameliorating, which may be necessary to prompt any re-rating. In fact, based on recent trading it’s easier to imagine the shares continuing to grind lower. That said, the price could potentially benefit were the company to decide to split up its hotel and coffee business which investors have long speculated about. There are rumours that activist investor and 3.4 per cent shareholder Sachem Head will push for this. Historically, management have been dismissive of the idea of a break-up, but recent rhetoric from the company seems a bit more agnostic.

Diageo

The problems faced by domestically-focused Whitbread, arguably shield it from the accusation of being an expensive 'bond proxy' at risk of de-rating as the yield on government bonds rise. However, for those who subscribe to the bond-proxy view, such fears are very much a consideration when it comes to drinks giant Diageo (DGE). The company has global reach and its top-class brands have driven an enviable track record of dividend and profit growth.  

However, investors are certainly expected to pay up for these attractions. In contrast to Whitbread, Diageo’s forward PE ratio, while down since the start of the year, is in the top 7 per cent of the 10-year range and the top 15 per cent of the five-year range. And while the shares’ dividend yield may be high by the standards of this screen, it is among the fifth lowest that the shares have offered over the past 10 years. A valuation that is so high by historic standards clearly carries more risk of presenting a headwind to returns. And if shares in high-quality dividend-paying companies have indeed become linked to bond prices, the downward momentum that has emerged for government bonds is a problem.

Valuation concerns aside, the business has been performing well. Cost cutting and sales growth meant the company delivered a good set of half-year results which were ahead of brokers’ expectations. Not everything was positive with a slight disappointment from North American growth and news that dollar weakness meant a £60m foreign exchange-related full-year profit hit is expected. Still, plenty enough to inspire confidence on the trading front.