3 shares with dividend potential

Over the long term, dividends can make up a huge proportion of total stock market returns .

When reinvested regularly they drive compound growth, where regular small increases add up to significant gains over the long term. That makes companies capable of delivering a steady flow of dividends over the long term a very attractive investment.

We've taken a closer look at three companies with very impressive dividend records to see what it takes for a business to become a strong dividend machine.

We should flag at the outset that none of these companies could be considered 'cheap'. They're quality growth businesses, pure and simple.

While their dividends might have shown remarkable resilience over the year, they don't offer substantial dividend yields in the 'here and now'. These are companies for those with an eye for the long term.

It's also worth reiterating that the world is full of uncertainties – as we saw in 2020 when lots of strong dividend records disappeared. No company is able to grow dividends indefinitely and past performance is not a guide to future returns.

This article isn't personal advice. If you're not sure whether an investment is right for you please seek advice. Investments rise and fall in value, so you could get back less than you put in.

Investing in an individual company is higher-risk and isn't right for everyone. Your investment is dependent on the fate of that company. If it fails, you risk losing your whole investment. Investors should only buy and hold individual shares as part of a well-balanced, diversified portfolio.

Remember no dividend is ever guaranteed, and yields aren't a reliable indicator of what you'll get in the future.

Croda – the cost of beauty

Croda develops, manufactures and sells specialist chemicals for everything from cosmetics, to agricultural products to automotive lubricants. That might sound dull, but as of the end of 2020 Croda has been able to grow its dividend for 29 years in a row.

The group's diverse range of end markets is a fundamental strength, and we saw that in action in 2020.

Chart showing divisional breakdown of Croda's core revenues and underlying profit (2020, £m)

Source: Croda 2020 Preliminary Results.

The pandemic caused severe disruption to the cosmetics industry, sparking a big decline in sales of high margin, high-end products and knocking results in Personal Care. Meanwhile disruption in the automotive and industrial space impacted sales in Performance Technologies as factories closed under national lockdowns.

However, at an underlying level the group as a whole actually managed to grow revenues by 2.3%. That's mainly thanks to a very strong showing in Life Sciences – with growth in agricultural products and the group agreeing to supply Pfizer with certain components for the Covid-19 vaccine. While overall profits declined modestly, we see that as a very positive result in a year with a lot of disruption.

Long term we think selling crucial, niche ingredients into a wide variety of end markets is a very attractive position to be in. Avoiding more generic products means gross margins came in at 45.5% last year – pretty impressive for a manufacturer – and that follows a period of steady improvement.

Cash generation was also healthy at £176.9m , despite an increase in capital expenditure.

In a normal year, growth from Croda's core business is likely to be steady rather than spectacular – industry wide demand for things like beauty products or agricultural seed enhancers is unlikely to suddenly explode. That's somewhat at odds with the group's price to earnings (PE) ratio of 30.8 and means acquisitions have a key role to play in future growth.

Last year the group completed two major acquisitions – Avanti in life sciences and Iberchem in consumer.

Avanti gives the group expertise in lipid nanoparticle systems – technology used to deliver mRNA vaccines like Pfizer-Biontech's. Iberchem specialises in flavour and fragrances, with a particular focus on emerging markets.

In both cases Croda hopes to drive "revenue synergies", selling existing products to newly acquired customers and newly acquired products to existing customers.

The two deals did drive an increase in net debt (readily available assets minus debt) last year, hitting £800.5m or 1.8 times cash profits (2019: £547.7m). That's far from high, but perhaps edging towards the point where we'd rather see debt falling than rising.

Together with the need to manage integrations and the elevated share price (which means a prospective yield of just 1.6%) that has created some risk in the group. Still you get what you pay for with Croda – a high quality business at a premium price tag.

See the latest Croda share price, charts and how to trade

Diploma – got our seal of approval

Diploma is a bit of an odd beast. The group sells a mish-mash of technically demanding, specialist products to industrial customers. What unites its products isn't any particular industry specialism, but the fact management believe each end market has similar, attractive fundamentals.

Sales are broken down into three broad categories – Seals (45% of revenue), Controls (29% of revenue) and Life Sciences (26% of revenue).

Chart showing Diploma's adjusted operating margin by division

Source: Diploma 2020 Preliminary Results.

Diploma looks to provide "essential products" to its customers, ideally consumable products used in repair and upgrade work on already owned equipment. These products are part of customers everyday operating costs – rather than capital expenditure – and that makes demand more predictable.

As with Croda, a wide range of customers helps reduce the risk of being overexposed to a downturn in a particular industry.

While all the divisions are distinct, the Seals business (the rubber kind you find in hydraulic pumps rather than the ocean dwelling variety) nicely encapsulates how the group operates.

When a piece of heavy equipment is serviced it usually has all the seals on its component checked and changed. Diploma provides customised packs with seals that match all the various components on the equipment (which might originally have come from a wide variety of different manufacturers).

These packs are relatively low cost, but dramatically increase the efficiency of the service. That allows Diploma to earn a healthy margin on what are essentially little pieces of rubber. Every service means another pack.

That sort of necessary spending meant 2020 sales fell just 1%, although the feedthrough to underlying operating profits was more dramatic with a 10% decline.

Free cash flow (the net amount of cash generated from operations minus the amount spent on capital expenditure) actually delivered a substantial improvement though, up 28%. That's a one-off boost as the group focussed on collecting cash from customers quicker, but supported a 3% increase in the full year dividend. That continues a run of dividend growth that stretches back into the late nineties.

Like Croda, Diploma leans heavily on acquisitions to underpin growth over the long term. The group generally favours small bolt-on deals that add scale or expertise to its existing product lines. Small deals are lower risk – and also get the most benefit from economies of scale once they're part of the Diploma group.

The challenge is that as the group gets bigger, the law of large numbers takes hold. When profits are larger, a greater number of small acquisitions are needed to significantly move the dial. That runs the risk that the quality of acquisitions declines.

So far, the group has avoided that particular trap, and with a PE ratio of 31.9 the market clearly thinks it can continue – still it's something to watch out for.

See the latest Diploma share price, charts and how to trade

Diageo – that's the spirit

Diageo is one of the world's largest manufacturers of spirits and beers. Brands range from Smirnoff, to Talisker and Guinness.

With a finger in every type of spirit you care to name, Diageo (like Croda and Diploma) is well diversified. That's crucial in the drinks industry because it's a market driven by trends. One year gin is the order of the day and next it's tequila, where Diageo saw sales rise 61% in the last six months of 2020 .

Chart showing Diageo's breakdown of net sales*

Source: Diageo, Interim Results 2020. *Six months to December 2020

Premium spirits are an attractive market because it's very difficult for new entrants to muscle in. It takes significant upfront investment to build a brand and whisky in particular takes years to age in a barrel. Potential competitors have to buy and invest in an existing brand, or be happy waiting a long time for their investment to pay off.

The fundamental economics of the business have allowed Diageo to build a formidable track record. Operating margins were above 25% every year in the decade leading up to 2020. The group's return on equity, which is a measure of how efficiently Diageo has deployed investors' money, is also strong and was 34.5% in 2019.

The second half of 2020 wasn't kind to Diageo – with sales down 4.5% and an 8.3% decline in operating profit as bars shut around the world. However, that didn't stop the group raising the half year dividend by 2% in January, extending a track record for dividend growth that stretches well over 20 years.

The decision to up the dividend reflects management's confidence that sales will recover quickly once bars re-open. We have some sympathy with that expectation. But with net debt to cash profits of 3.4 times, some way above the group's long-term target, there's work to be done sorting out the balance sheet.

That probably goes some way towards explaining why the shares offer a prospective dividend yield of 2.5%, somewhat higher than the other stocks we've discussed.

Ultimately, we think Diageo and its formidable stable of brands are resilient enough to withstand further disruption, while well positioned to enjoy a recovery in the economy. But the sooner that recovery comes the better.

See the latest Diageo share price, charts and how to trade

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.

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