The strong and stable stocks offering a reliable income

Nothing beats cold hard cash. In bull markets, investors are busy chasing rising stock prices; when the cycle turns, they rediscover the appeal of a steady dividend. No wonder. Reinvested income accounts for the vast majority of long-term returns. As the latest annual Barclays Equity Gilt Study notes, a £100 stake on UK equities in 1945 would have been worth £6,294 in real terms at the end of last year, assuming the gross income had been reinvested every year. Without dividend reinvestment, the £100 would barely have tripled after inflation. Now that global markets are wobbling, defensive stocks offering safe dividend yields and the prospect of at least some share-price growth are especially sought after.

That combination appeals more than cash accounts offering paltry interest rates, especially as British income stocks look historically cheap (see bottom).

A 25-year record

A good dividend stock is safe and reliable. A special few have increased their dividends every year for at least 25 years. I think of them as the "dividend aristocrats". This kind of consistency is crucial as you do not want to buy a stock for income only to find the payout is suddenly reduced or cancelled, a change that is inevitably accompanied by a major share-price fall: witness Tesco's 50% slide in 2014 after it admitted to overstating its profits and scrapped the payout for two years.

"£100 in 1945 would be worth £6,294 now with income reinvested"

Dividend aristocrats with at least 25 years of consecutive increases form a very select group. There are only 53 in the S&P 500, for instance. A handful of firms are dividend "super-aristocrats", having increased their dividends each year for more than50 years; in three cases, for more than 60. Before we take a closer look at the aristocrats, however, considersome simple tests that investors can use to checkthat a company is likely to carry on paying and increasing its dividend.

Avoiding a dividend disaster

Even if a company has raised dividends for more than 25 years, investors should still apply three simple checks. The first is to look at dividend cover, the ratio of earnings-per-share (EPS) to the dividend-per-share (DPS). A ratio of two or more the payout is at least twice covered by earnings, in other words is healthy in this context.

You should also gauge whether free cash flow per share is comparable to EPS, which indicates that profits are backed up by cash generation rather than stemming from creative accounting. Free cash flow should certainly be much larger than the cost of the dividend. The third step is to check that the company either has net cash on the balance sheet or only modest debt. One way to do this is to find the debt/ebitda (earnings before interest, depreciation and amortisation) ratio, which captures the relationship between debt and operating earnings. If debt is too high in relation to operating cash generation, there is a danger the money the company generates may have to go towards reducing borrowings rather than paying investors an income. A ratio above two looks precarious; I prefer a ratio of one or less.

The clues at Cobham

A case where these criteria would have provided a useful warning was UK aerospace group Cobham, which pioneered air-to-air refuelling. The Daily Telegraph reported in 2013 that Cobham had increased its dividend every year for 43 years. It went on to increase it up to the 2015 financial year, but a series of acquisitions paid for with increasing debt and problems at one US purchase stretched its finances and it paid no dividends at all in 2017 and 2018. However, the preliminary results for the year to 31 December 2015 showed negative dividend cover (a loss of 3.3p but DPS of 11.18p), even though analysts focused on "underlying" EPS of 19.5p. In addition, free cash flow was less than the cost of the dividend and net debt stood at £1.2bn, yielding a debt/ebitda ratio of 2.9. So all three warning signs were there.

My top-15 dividend aristocrats

We now look at 15 dividend aristocrats. All but one have current dividend yields of more than 2.1% and boast at least 25 years of increasing dividends with six super-aristocrats managing more than 50 years. The modest yield criterion of at least 2.1% enables the inclusion of companies from a wide range of sectors. Companies with very high dividend yields often offer poor share-price growth, whereas modest dividend yields from a fast-growing company can, after several years, yield both large capital gains and a high yield on the original investment.

The UK dividend champion

Britain's Halma (LSE: HLMA) is a good example of this mixture and illustrates why a dash of growth, not merely a high income, is important. The blue-chip occupational-safety, health and environmental protection group boasts an incomparable record: it has increased its dividend by 5% or more every year for the last 39 years. And those rising dividends have been accompanied by substantial share-price growth: the stock rose from 41p in October 1988 to 1,504pin October 2018, a 36-fold increase in 30 years.It announced a dividend of 7.18p in June 2007, when the share price was 240p, giving a yield of 3%.

"Halma is a good example of why a dash of growth, not just a high income, is important in the long term"

But by June 2018 the dividend had risen to 14.68p and the share price to 1,424p, giving a yield of 1.03%. However, that meant an investor who bought in June 2007 had a yield in 2018 of 6.1% on his original investment and that investment was worth six times its 2007 cost. That overall return is far better than an income investment with a high dividend yield of 5% in 2007 and a modest increase in value of, say, 60%.

The table above highlights another 14 companies that have increased their dividends every year for between 28 and 63 years. They have intentionally been chosen from 15 different sectors and 14 of them span respectable yields from 2.1% to 4.2%, with Halma at 1.1% added owing to its incomparable record of dividend increases and total returns. The financial crisis of 2008/2009 saw many companies cut or hold their dividends but these 15 continued to increase them. All the companies also show positive annualised total returns over both the last ten years and the last three years.

America's top income stocks

The first is the oil firm Chevron (NYSE: CVX). Consolidated Edison (NYSE: ED) represents utilities. SSE was an option here with 26 years of increasing dividends and a yield of 8.8%, but it has two drawbacks. The first is that the dividend is barely covered, while the second is political risk: if the Labour Party won an election, SSE would probably be nationalised with poor compensation.

These two are followed by beverage leader Coca-Cola (NYSE: KO) and Procter & Gamble (NYSE: PG), an obvious choice in the household and personal-care category since Unilever only has a record of 19 years of dividend increases. Then there is James Halstead (Aim: JHD), the UK flooring company, and 3M (NYSE: MMM), the innovative diversified industrials company, which invented Post-it notes, with a 60-year record. These are followed by Johnson & Johnson (NYSE: JNJ) from pharmaceuticals with a 54-year record and Britain's car-engine catalyst and battery materials group Johnson Matthey (LSE: JMAT). Tightening emissions regulations continue to provide growth, and battery materials and components should expand withelectric vehicles.

Due to the financial crisis very few banks and financial firms are dividend aristocrats. An exception is Cincinnati Financial (Nasdaq: CINF), which has a 57-year record of increasing dividends.A rare software aristocrat is the UK's Sage (LSE: SGE), with a 26-year record.

The final four companies include Dover (NYSE: DOV), an engineering-systems specialist famous for refrigeration and food equipment. It boasts one of the longest records of dividend increases in the world: 63 years. McDonald's (NYSE: MCD) represents the food industry with a 42-year run. Then there is Medtronic (NYSE: MDT), the largest investor in research and development in the global health sector; and ADP (Nasdaq: ADP), the outsourcer specialising in human-capital management, payroll, attendance and compliance. Twelve of these 15 companies show double-digit returns per year over the last ten years. Halma is again the standout in this respect, with a 23.2% annualised return over the last ten years. It has done almost as well over the past three.

Investment-trust aristocrats

Any portfolio of dividend aristocrats should be diversified across different sectors and countries to provide additional protection and dilute the impact of the very occasional problem company, such as Cobham. An alternative way of gaining diversification is to use investment trusts (ITs). One of the many advantages of an investment trust over a unit trust is that it is allowed to set aside 15% of annual income as a reserve. This reserve enables an IT to plan its dividend payouts to achieve steady increases. Some ITs have raised dividends for 40 years or more. Six of the 15 IT aristocrats with over 30 years of dividend increases are listed in the table below. These have been selected to illustrate a wide range of yields, (discounts/premiums) and share-price performances.

"Thanks to the financial crisis very few banks are dividend aristocrats"

As with shares, higher yields tend to be accompanied by lower growth. It is important to take a look at the top-ten investments of any trust you are considering investing in to understand the type of company the manager favours for its portfolio. Check too whether the trust is selling at a discount or a premium to its net asset value: whether the trust's market cap is lower or higher than the value of the shares and cash it holds. To illustrate the differences in approach taken by different ITs, we will briefly examine the portfolios of the highest and lowest dividend-yield ITs. Scottish Mortgage (LSE: SMT) IT has the lowest yield so it is not surprising that its top-ten investments contain Amazon (9.3% of assets), Illumina (8.2%), Tesla (6.6%) and Tencent (5.3%). Three of these companies do not pay dividends and the fourth (Tencent) has a yield of only 0.33%.

By contrast, City of London's (Aim: CIN) top-ten investments include dividend paying companies such as Shell (6.9%), HSBC (4.5%), BP (4%), Diageo (3.3%) and Unilever (2.9%). These examples illustrate the difference between an IT such as Scottish Mortgage, which emphasises growth, and City of London, which emphasises stable and substantial income. That is why Scottish Mortgage has averaged share-price growth of 24% over ten years and 27% over the last three well above that of City of London, which has averaged 11.6% over ten years and 7.7% per year over three years. But City of London has a yield that is more than seven times larger than Scottish Mortgage's. Meanwhile, the other trust aristocrats worth researching are Caledonia Investments (LSE: CLDN); Scottish American (LSE: SCAM); Scottish (LSE: SCIN); and Bankers (LSE: BNKR).

Mix and match

Investors have three basic options. More income-orientated investors can select two or three investment trusts offering fairly high dividends. Alternatively, mix one or two growth trusts with a couple of income trusts to provide a lower income but a greater growth element. The third way is to select your own portfolio from companies such as those in the table above.

A set of 15-20 companies from different sectors and countries will provide adequate diversification, but still be small enough for you to keep track of the performance of the constituent companies. Just ensure your expectations are realistic: remember that higher-yielding dividend stocks or ITs imply lower capital appreciation and vice versa.

UK dividend yields are at post-crisis highs

Dividend payouts by UK companies hit an all-time high of nearly £100bn last year, writes John Stepek. That was up 5.1% on the year before, according to Link Asset Services. And when you exclude special dividends (one-off returns of cash), the rise in underlying dividend payouts was even higher, at 8.7%, with banks and miners accounting for most of the growth. Combined with a grim year for share prices in 2018, that's left UK stocks sitting on dividend yields that are higher than anything we've seen since the financial crisis era.

One safety point we always emphasise is that unusually high dividend yields tend to imply there's trouble down the road. A high-yielding stock often means that the market believes a dividend cut is coming soon. Yet even if there is trouble on the horizon (in the form of recession or major Brexit disruption, or both), dividends are unlikely to fall by as much as today's high yields would indicate, Justin Cooper of Link Market Services tells Javier Espinoza of the Financial Times. Any drop "is likely to be in the 10%-15% range, not the 25% or so currently implied".

As we've pointed out in recent issues, there are some solid investment trusts offering exposure to high-yielding UK stocks. However, if you fancy investing in individual stocks, Jonathan Jones in The Daily Telegraph highlighted nine "dividend heroes" stocks that have been in the FTSE 100 since its inception and are now yielding more than 5%. If you are comfortable investing in tobacco stocks, then British American Tobacco (LSE: BATS) yields more than 7%, having halved in value in the last 18 months. Insurer Legal & General (LSE: LGEN) looks less vulnerable on a yield of well over 6%, and miner Rio Tinto (LSE: RIO) and pharma giant GlaxoSmithKline (LSE: GSK) both yield more than 5%.