In this article I want to cover five ways to find companies capable of paying an increasing dividend. To my mind high quality dividend shares have the potential to help a portfolio perform well over a long timeframe. Why? Because if a company can raise its dividend year after year while increasing profits it shows management is confident, is likely allocating capital well and that the business model has proven, in the past at least, to be pretty resilient.
Given markets are often uncertain, this last point is pretty important. Dividend shares reduce the reliance only on capital growth. Holding great dividend shares I think can increase total return. But it is important to find the right ones and not focus only on the headline yield.
Five ways to find above-average dividend shares that could do well over the long-term
1) Don’t focus just on dividend yield
This may seem counterintuitive to some. But it’s likely a mistake to invest only based on high yielding shares. First, the yield could be high because other investors think there’s big challenges ahead for the company. As such the dividend is making up to some extent for an expected loss of capital.
While there is an ‘investing in dogs’ style of investing, which looks to invest only in the highest yielding shares, it’s probably not worth the risk. The exception may be where there are strong catalysts for change and a possible rerating.
For the long term it’s very likely better to focus on more than just the yield.
2) Look for a high and/or consistent dividend cover
Rather than focus on the dividend yield, which can rise just because the share price is falling, I’d focus instead on dividend cover as a way to find great dividend paying shares.
There’s no unbreakable rule when it comes to dividend cover. A cover that is 2x earnings per share, or more, is often seen as a way to find dividends that are pretty safe from being cut. However, utilities and other industries with predictable earnings may well have a lower level of cover. REITs as well seem to often operate with low levels of dividend cover.
As with many aspects of choosing a share to invest in, it’s often wise to compare a company to others in its industry. Sometimes you can find an industry leader that has a lot of potential but it doesn’t stand out when looking at the whole market because it fails on some other criteria like lower levels of return on capital employed, or low revenue growth etc…, which might just be common in that industry.
3) Look for high and/or consistent dividend growth
As well as a decent level of dividend cover, which makes the dividend less vulnerable to a cut if profits and earnings fall, it’s also good to see a history, of probably at least five years, of either relatively high or stable, consistent dividend growth.
As with dividend cover, different industries will see very distinct levels of dividend growth. Size also matters! Smaller companies should be able to provide greater levels of dividend growth than more mature businesses.
4) Look for dividend shares with high barriers to entry and stable or even growing market dynamics
Dividends can ultimately only be sustained if the business itself is in good shape both at the current time and looking into the future (as far as that is ever possible!)
To find great dividend shares it pays to focus on those companies that have good moats protecting their business. This should give them a sustained commercial advantage. In turn, there should be profits and free cash flow from which to pay a sustainable, growing dividend.
Again, this comes back to the central point, which is that it’s important to look beyond just the yield if you want to find the very best dividend shares.
5) Make sure margins aren’t retreating
Ultimately to find sustainable dividends that can grow out into the future, it’s best to find high quality companies. As an aside, the trick is then to buy them at a fair value. Anyway, for now we’re focusing on finding quality companies with dividend potential. One way to do that is to look at profit margins.
Unless there’s a good reason (investment in marketing or assets to facilitate future growth, bolt on acquisitions etc…) you don’t want to see margins retreating. This is particularly true in low margin businesses because any knock could soon see sentiment turn against the company and the share price fall.
These then are five considerations to keep in mind when it comes to finding dividend shares that might be worth investing in. Thankfully, many UK listed companies pay out a dividend to shareholders so there are examples of shares that could meet all, or much, of the above criteria.
Examples of UK dividend shares
The first share that seems to meet much of the criteria laid out above is Best of the Best. When I screen via Stockopedia for shares with nine years of dividend growth, dividend cover of two or more, dividend per share growth of 15% or more, three year dividend per share CAGR greater than 15% and finally return on average assets at or above 15% – the final one as a yardstick on the quality of the business – it came up.
Best of the Best runs “skills-based” online games company offering luxury cars as prizes. Although it may look good from a fundamentals and dividend perspective, its worth noting that its shares fell sharply recently, so investors should be extra cautious with this company.
Private investor favorite Games Workshop also meets the criteria as does Gulf Investment Fund which has, at the time of writing, a Stockopedia Stockrank score of 94.
The Ukrainian iron ore miner Ferrrexpo is another share that tends to come up when I screen for high quality dividend shares, although it didn’t quite meet all the criteria above. There was no dividend in 2016, so I expect it’s on the track record of dividend growth where it falls below the required criteria.
Meeting these criteria doesn’t necessarily mean these shares are worth investing in. Only you can decide that. However, they do seem to show signs of potentially being very good dividend shares.
Please note I own shares in Ferrexpo at the time this article was published. As always please do your own research, this article is only intended to express my thoughts.
Thanks very much for reading. If you’ve enjoyed this article, please do read my previous article on the changes to my UK investment portfolio in September.
You can also share this article on Twitter or can follow me on Instagram (incomeinvestoruk).