How to find strong dividend-payers

With traditional sources of income delivering below the rate of inflation, it's no surprise investors are turning to stocks that pay generous dividends. Tim Bennett explains what to look out for.

Life is tough for income investors just now. Traditional sources of income, such as government bonds and highly rated corporate bonds, offer returns that are far below the rate of inflation. So many are turning to dividend-paying shares instead.

To keep paying out, companies need cash. The good news is that they currently have plenty of it. As Gillian Tett notes in the Financial Times, 41% of corporate treasurers reported a rise in cash holdings this year. It's the same in Europe. With fear levels still high, firms are unwilling to commit to big investment projects.

However, having a lot of cash doesn't necessarily make a company a good income investment. Cash can be wasted on projects that lead nowhere, or on expensive acquisitions that never repay their original outlay. So how do you track down stocks that are both able and willing to return lots of cash to shareholders?

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Don't buy stingy stocks

You don't buy shares so that a firm can sit on your cash. That's what banks are for. If a firm can't think of anything better to do with your money, it should repay it in the form of dividends (or share buybacks). And you don't just want your cash now you want an income stream for the future.

Even if you're not looking for income specifically, it's worth monitoring cash returns. Graham Secker and his team at Morgan Stanley found that between 2007 and 2011 stocks that pay regular high dividends have beaten those that don't. That's not a huge surprise: amid today's uncertainty, investors care more about security and balance-sheet strength than growth. This is why Secker looks for firms that not only generate heavy cash flows but also plan to return a good chunk of it. Here are four tests to help you find reliable and persistent income payers.

1. An increase in cash returns

The first test is the simplest you want to find stocks that have announced either significant share buybacks or, better still, an increase in dividends per share over the past year. But this is just the starting point.

2. High cash levels

The next step is to determine just how much cash a firm has. Morgan Stanley screens for three things. Firstly, it compares the firm's cash levels to its market capitalisation this is to check that cash levels are high relative to the firm's size.

Secondly, it checks the cash isn't swamped by debt. A firm with large debts, like a man with a big mortgage, may be tempted to use its cash to clear it, which threatens future dividends. So Morgan Stanley excludes any stock where net debt (cash plus short-term investments, minus short-term debt) is above 50% of shareholders' equity.

The other threat to cash levels is a pension deficit. This is when the value of assets in a company pension fund falls below the cost of its future obligations to retirees. A firm with lots of cash might be tempted to plug this deficit with the spare money. But we want to see it paid out as dividends instead. So the final screen is to exclude any firm that has a pension liability larger than 10% of its market capitalisation.

3. A low payout ratio

Another test tries to gauge whether a firm can sustain its dividend payout in the future. Secker's team looks for firms where the dividend payout ratio is close to a ten-year low.

The payout ratio is just the proportion of a firm's profits that it pays out as a dividend. So if profits are £100m and the annual dividend is £50m, the payout ratio is 50%. The higher the ratio, the less scope the firm has to raise dividends in the future. This is especially important today, given that in the current tough climate no one expects firms to grow profits significantly. That's why a historically low payout ratio is attractive it suggests that a firm is in a position to boost its dividend returns to shareholders, even if profits stagnate.

4. Cash generation potential

Finally, Morgan Stanley applies a few more ratios to try and determine whether a firm has the potential to grow its cash returns in the future. The two key ones are the free cash flow (FCF) yield and earnings per share (EPS) volatility over the last ten years. As for EPS volatility, the higher it is, the worse the prospects for consistent cash flow generation. So you want a company where earnings are relatively stable.

Best buys for income

The aim is to find firms that have raised payouts recently; that have a decent cash pile, and face few obvious future financial calls on it; have room to boost dividends; and can generate the future cash needed to do so.

No single firm fits every one of the criteria, but one that makes the Morgan Stanley cut is advertising giant WPP (LSE: WPP). Although it has suffered recently as clients cut advertising spending, Motley Fool calls it "the ultimate retirement share" for its ability to grow dividends in line with earnings, and consistently to hit a payout target of 40%. The yield is 3.1%. Another option is French drug giant Sanofi (Paris: SAN), which yields around 3.9%.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.