George Salmon 29 September 2017
When I recently wrote about how to select income shares, I explained why there’s more to it than simply looking at the yield.
For me, a company able to grow its dividend over time is much more attractive than one with a high yield now, but with limited scope for growth. We also need to remember the lessons history teaches us about the relative stability of some sectors over others.
With these ideas in mind, I set out to identify companies with enough earnings and free cash flow to cover their dividends, and which offer a prospective yield of at least 2.5%. Prospective yields are based on analyst forecasts of future dividends rather than the dividends paid in the past, so we think they are more useful when picking stocks.
I’ve also added the requirement for these companies to have built a consistent record of dividend growth dating back to before the financial crisis, and for analysts to be expecting more increases in the future. However, always remember that past performance is no guide to the future, and even companies with long track records could cut their dividends. All investments and income can fall as well as rise in value so could get back less than you invest.
Prospective yield 3.2% (variable and not a reliable indicator of future income)
Love it or hate it, the world is getting smaller.
While Marmite may not yet be a global phenomenon (outside of the UK & Ireland, the only location you can buy it is, rather curiously, Sri Lanka), you can find Unilever brands such as Dove and Domestos in supermarkets across the globe.
In fact, Unilever claims that around 2.5bn people use a product from at least one of its stable of 400 or so brands every day. This range and diversity is a key strength of the group.
Another strong point is its exposure to emerging markets. Over time, we expect to see both the population and average income of many developing nations in Asia and Latin America rise. In turn, this growth should translate to higher spending on everyday products, which Unilever, with the help of its €8bn marketing budget, will hope to hoover up. Investors should be aware that growth in emerging markets will likely fluctuate, so even if the long-term potential is realised, it may not be a straightforward journey.
Shortly after fending off an ambitious takeover from Kraft Heinz earlier this year, CEO Paul Polman unveiled plans to supercharge shareholder returns and margins. Perhaps due to this higher growth potential, the shares trade on a price to earnings ratio of 20.4, significantly above their longer term average of 16.9.
Prospective yield 2.7% (variable and not a reliable indicator of future income)
It’s been an eventful year for plastic packaging manufacturer RPC.
It spent £511m acquiring US rival Letica - its first meaningful step into the vast North American market.
Results this year have been good, but the share price didn’t initially follow suit. Investor sentiment towards the stock cooled as concerns surfaced over whether acquisitions are masking a poor underlying performance.
But acquisitions have been an integral part of the RPC story for many years, and a series of successful integrations have helped it build a track record of dividend growth stretching all the way back to the early 1990s.
Potential investors should be aware this expansion has historically been funded by rights issues. These haven’t impacted the group’s dividend, but since many have been launched at a discount to the prevailing price, investors choosing not to invest further in the company have seen their holdings diluted. On the other hand, participating investors have had the opportunity to top up at what have proven to be attractive prices.
The shares currently trade on 13 times expected earnings, which is above the historic average of 11.
Prospective yield 2.9% (variable and not a reliable indicator of future income)
Paddy Power Betfair was formed following the merger of Irish bookmaker Paddy Power and fast-growing online operation Betfair. While united under the same banner, a £293m sales and marketing budget has built a distinct image for each brand.
Paddy Power focuses on the Holy Grail for all bookies, the fun-seeking punter. This customer doesn’t aggressively shop around for the best odds, and is casual enough to come back for the occasional bet time and again. The retail business can already boast a higher level of profit per shop than its UK rivals, but there’s some room for improvement in win margins.
Betfair, on the other hand, caters to a more value-conscious punter. The brand has a sportsbook and an exchange, which enables customers to cut out the middle man and bet directly against each other. Rather than being exposed to the sporting gods, this provides a more reliable income stream. Betfair simply takes a cut of the winnings as commission.
With the bulk of business done online, relatively little capital is tied up within the business so over 90% of profits feed through to free cash flow.
As ever with the bookies, regulation is a worry. Taxes in Australia could rise, while closer to home the results of a government review into fixed odds betting terminals is expected soon. With machine revenue of close to £100m last year, Paddy Power would feel the impact, but its online focus means the impact would surely be more severe elsewhere in the sector.
The shares trade on a price to earnings ratio of 17.6, slightly below their long-term average.
Prospective yield 2.9% (variable and not a reliable indicator of future income)
Ultra Electronics’ software can be found in military craft on air, land and sea, in major surveillance and IT security packages, and is also used in nuclear safety systems.
While the business lines may be varied, tying the group together is a focus on finding innovative solutions to complex problems. Indeed, at 4.3% of turnover plus customer contributions, Ultra has one of the highest R&D spends in its industry.
Once it has found a solution, its software is then protected by intellectual property rights, meaning cash generation is very strong. With contracts often spanning several years, it has valuable visibility of future revenues too.
However, organic revenue growth has been sluggish recently. To combat this, Ultra has successfully implemented plans to improve margins, and has agreed a deal to acquire US group Sparton for $235m.
The two had previously been working in partnership on a project for the US Navy. Investors will be hoping that this deal can help get growth going again, although the size of the deal does bring extra risk.
The shares trade on a price to earnings ratio of 12.7, compared to a longer-term average of 13.8.
Prospective yield 3.5% (variable and not a reliable indicator of future income)
For my fifth choice, I’m taking a trip across the Atlantic.
You don’t need me to tell you that Coca Cola has been a staple for generations. However, to remind ourselves of the power of its brand, it is worth remembering how the word Coke is used interchangeably with Cola. This might not seem too significant, but have you ever heard anyone ask for a ‘rum and Pepsi’?
It’s not a one trick pony either. The group owns 20 other brands that generate annual revenues of over a billion dollars, including Fanta, Sprite and Minute Maid.
Some have raised concerns that the world’s thirst for Coca-Cola might dry up because of the health impact of sugary drinks. However, with revenues continuing to grow on an underlying basis, the group has grown its North American market share for 29 consecutive quarters and pre-tax margins remain impressively high at over 25%.
With the stock priced in dollars, the cost of buying in for a sterling investor has increased, but so has the sterling value of its dividends. The prospective yield on offer is currently 3.5%.
The last 55 years have not only seen Coca-Cola grow to become one of the most recognisable names in the world, but has also seen a remarkable string of dividend increases, without a single dividend cut in that entire period. Please remember however, that this doesn’t guarantee another 55 years, however nice that would be for shareholders!
Investors buying the shares now will be paying 23.4 times expected earnings, more than the average of the last 10 years of 18.3.
Before buying US shares, you must complete and return a W-8BEN form - a declaration you are not resident in the US.
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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information. George Salmon owns shares in RPC Group.