With FTSE companies slashing their dividends left, right and centre, income investors are fretting. Which stocks will continue to pay good dividends and which have them on the chopping block or are likely to over the next months and years? While there is no crystal ball that can be peered into to provide absolute certainty on which UK companies will continue to offer the best dividend returns over the medium term, fund data company Morningstar does publish a monthly league table of what its analysts believe are the best income stocks in the FTSE All-Share.
Let’s take a look at why it’s probably set to get trickier for income investors, the methodology behind Morningstar’s dividends league table and delve into its top 10 options.
How Can Investors Spot Stocks With Long Term Dividends Potential?
It sounds like a contradiction but 2019 is expected to see London-listed stocks set a new dividend payout record while we’re simultaneously in the midst of a bout of announcements from companies on dividends being suspended, reduced or at future risk. The present UK income stocks scenario is less of a contradiction as it is a sign that we may well have reached the peak of the current dividends cycle.
The impressive dividends totals being racked up this year are less impressive when examined more closely. It becomes apparent that as much of 50% of the £107 billion expected to be paid out to investors this year comes as a result of the falling value of the pound. Because so many of the biggest FTSE dividend payers earn much of their income internationally in different currencies, a weaker pound helps boost their bottom line as revenues and profits realised in other currencies exchange into more pounds on the accounts – and higher dividends paid out in sterling.
But that’s not a sign of sustainable health of the underlying business because currency swings could just as easily move the other way next year or the year after. Investors looking for sustainable long term dividends should look at average long term dividends adjusted for currency fluctuations. In the same spirit, special dividends should also be ignored. Special dividends are bonus dividends added to the ‘regular’ dividends that companies pay, or don’t usually pay.
Because companies try not to reduce dividends if they can help it and aim to maintain a steady dividend growth trajectory, they want to ensure that is practically possible. So when a company has a particularly good year or generates a big cash lump sum because, for example, they sold a unit, the most common approach is to pay out a ‘special’ dividend. That represents a nice sweetener for investors and keeps them onside but doesn’t create unrealistic expectations the special dividend will become a regular occurrence. And because analysts look for a steady and sustainable pattern of stability or growth in dividend payments, separating out special dividends helps income stocks meet that criteria and avoid a volatile dividends trend line. So discounting special dividends just makes sense. As an income investor, be happy when they turn up but don’t bank on them. Instead, bank on not receiving special dividends.
The Morningstar methodology also takes into consideration a forward dividend yield estimate. That is based on the company’s current share price and forward guidance issued on dividends. A star rating adds another layer and reflects whether Morningstar analysts believe an income stock is currently over or under valued with a high score for undervalued and low for overvalued. An undervalued income stock would be expected to realise future capital gains as well as dividend yield while an overvalued income stock would be expected to possible see a market capitalisation and share price drop.
Finally, the income stocks league table estimates the ‘economic moat’ protecting future dividends. So if a company has a particularly large cash pile and/or considered especially undervalued by the market, and the current dividend rate doesn’t look excessive, there is a higher likelihood of future dividend levels being maintained or increased.
Let’s take a look at Morningstar’s top 10-rated income stocks as of August 2019:
Imperial Brands is in first place on the dividends leader board with a current yield of 9.32% and a forward yield estimate of 6.11%. Crucially, while income stocks lower on the list have higher forward yield figures, Imperial’s stable history of dividend payments, the fact it is currently considered an undervalued stock and the company’s wide ‘economic moat’ ensures it is judged the safest income bet on the London Stock Exchange based on current data.
As a tobacco company, however, shares in Imperial Brands may not fit the investment strategy of those with ESG considerations. Long term, there is also a question how big tobacco companies evolve to stay relevant in a future in which the current trend of falling numbers of smokers is expected to continue. So while the immediate prospects look good for Imperial as an income stock, the company is certainly in a market with a less than certain long term outlook.
SSE comes in second in the Morningstar dividend stocks lead table despite the fact the Perth, Scotland headquartered energy utility has, at 9.08%, a significantly better forward yield than Imperial. However, the fact that SSE’s economic moat is considered narrower means the medium to longer term outlook for the dividend is not quite so assured. It’s also considered the stock’s current valuation leaves room for some upside but is not as undervalued as Imperial’s.
BT is in a similar situation. The telecom offers a current dividend yield of 8.24% and an even better forward yield of 8.37%. The summer 2019 share price leaves some room for upside with a 4-star rating but the company’s economic moat is judged as narrow. BT is faced with some major infrastructure expenses over coming years as the UK mobile network upgrades for 5G.
British American Tobacco comes in at fourth place, with another tobacco company in the top spots demonstrating the cash pile they are sitting on. Again, ESG concerns or the unclear long term outlook for the industry could put some investors off but over the next few years BAT still looks a solid income stock choice. Current and future yields are 6.68% and 6.81% respectively, the company has a wide economic moat and its stock is considered undervalued.
WPP is the multinational advertising and PR agency founded my Martin Sorrell, who last year left the company in some controversy. The knock-on effect of that has seen the company’s share price depressed to the point it is currently considered significantly undervalued by Morningstar analysts. WPP also pays a healthy 6.63% dividend yield, with the forward yield at the same figure. A narrow economic moat is the only obvious cloud on the horizon for this income stock.
Royal Dutch Shell B is one of two RDS share classes listed on the LSE and the one ranked by Morningstar as the 6th best dividend stock out there. The current yield is 6.28% rising to a 6.61% future yield. The share price looks like it is a bit of a bargain currently but the economic moat protecting future dividend levels is considered narrow. With the energy industry set to change significantly over the next few decades as renewables slowly take over from fossil fuels, the long term outlook for big oil and gas companies is closely tied to their ability to adapt to the changing landscape.
BP, the UK’s other big oil ‘supermajor’ comes in just after peer RDS with a dividend yield of 6.26% and future yield of 6.62% almost exactly the same. The current valuation of BP is also assigned four stars, meaning there is room for upside and another narrow economic moat means there is little to separate this income stock from the one that squeezes into the league table just ahead of it.
HSBC is the only bank to make the Morningstar top 10 dividend prospects despite the banking sector’s reputation for producing income stocks. Margins and riskier profit-making have been squeezed by new retail banking ringfencing rules and capital requirements. But HSBC is still going strong, offering a current dividend yield of 6.24%, easing to a 5.24% future yield. The bank’s current economic moat is considered narrow though but the share price also looks good value at its present level.
Vodafone, like telecoms peer BT, also makes the list despite recently warning it is reducing its dividend and may have to cut it to fund 5G infrastructure investment. Both current and future yield is 5.48% and economic moat narrow. However, it can be presumed that Morningstar’s analysts are confident that any short term hit to dividends to raise the cash needed for 5G rollout will be a blip with the Vodafone looking reliable longer term.
GlaxoSmithKline is the last income stock to make the top 10 list. The pharmaceuticals giant currently pays a yield of 4.86%, easing slightly to 4.61% for future yield. The solid dividend prospects are backed up by a wide economic moat, with GSK sitting on a big cash pile. The stock is, however, currently considered fair value so wouldn’t be expected to see any particularly impressive capital gains.
There is of course no guarantee that these stocks won’t cut their dividends in future or that others won’t end up performing better. However, Morningstar’s series of filters and criteria do offer as solid a basis as investors are likely to find when it comes to assessing the chances of an income stock continuing to offer strong dividends and general prospects.