We believe that these meanings are two sides of the same successful income investing coin. Here we explain why and illustrate it with three examples.
High yielding companies are those which can distribute a large proportion of earnings since these are not needed to fund future growth. There are many companies which can maintain a high and growing level of income, but some may be over-distributing and/or facing declining earnings, meaning the apparent high yield is a short-term phenomenon.
Recent offenders include previous income stalwarts such as Tesco, BP and most UK banks. It may seem as if these big high yielding companies stay around for ever, but just look at a list of the top 10 UK companies from 10 years ago and see just how many fail.
Notably, banking forms just 7 per cent of the 10 largest UK listed companies in June 2014 as compared to over 20 per cent in 2004.
FTSE 100 constituents
30 June 2004 30 June 2014
Source: Alliance Trust
Questions to ask
When we assess these high yielders we ask the following questions:
1) Is the outlook for the key components of financial health, namely profits, free cash flow and the balance sheet, favourable?
Though many factors determine the dividend policy of a company, the outlook for profits, how the company generates cash flow and the strength of the balance sheet, all act as a platform for having confidence in future dividend growth.
2) What is the dividend history of the company and do they have a clear and positive dividend policy?
Companies who have a long history of dividend payments and growth, have shown good financial management and health historically and this should give confidence for the future. We also view positive companies that have a clear and positive dividend policy. This shows confidence in the future and a commitment to the shareholder.
3) Are management and shareholders’ interests aligned?
A company with shareholder interests at heart will invariably reflect this in a positive dividend.
4) Does the valuation of the company allow for the prospect of good long-term investment returns?
Identifying good companies with attractive yields and dividend growth is all very well but our analysis ensures that the prospects for good investment returns in the long term are also there. We look at the longer-term nature of the business the company operates in, and we believe that companies which are aligned with the goals of sustainable development have an advantage. In short, companies whose product or service is clearly a benefit to society will be supported by that society. This leads to our identification of four long-term themes which are used alongside the income checklist. One consequence of this approach is that we believe tobacco companies’ dividends to be unsustainable.
Four long-term themes for sustainable income investing
Climate change and energy efficiency: The way in which we consume energy needs to change dramatically to ensure security of supply, reduce our greenhouse gas emissions and improve poor local air quality. This touches many areas including primary energy sources (oil & gas, coal), lower carbon generation and energy efficiency in our homes, industry and how we travel.
Sustainable consumption: This is about achieving more with the resources we have and finding ways to reuse and recycle in key areas such as water and rare metals, as well as reducing the often unintended negative consequences of industry and industrialised agriculture.
Quality of life: This relates to finding companies that provide unmet medical needs which improve quality of life (such as cost effective vaccines), or help to educate people. These types of services are in demand and are often being driven by changing demographics.
Resilience: We need to ensure that the systems we rely on are robust. For example, technological changes have led to huge increases in data and online use – ensuring this is secure, and that it is stored in an energy efficient manner, are big challenges which will reward companies which offer solutions to these.
Being exposed in a positive way to any of these themes, on its own, does not automatically mean we invest in a company. We go on to look at the business fundamentals – can the company grow in a profitable manner – and what we think the company could be worth to complete the picture on whether this becomes an investment, which we believe will generate superior investment returns.
Three stocks that fit the bill
With all of the above in mind, here are three stocks like:
Legal and General (L&G): A rare example of a company with strong income characteristics and earnings growth. There is a strong correlation between insurance penetration and economic development. By spreading risk and helping people to provide for their retirement, L&G’s service help to create a more prosperous and resilient society.
The Renewable Infrastructure Group: This company invests in a range of renewable generating assets, both solar and wind in the UK and France. The majority of its contracts are inflation linked, meaning that the dividend is largely protected from a rise in inflation. Underlying demand for their electricity is underpinned by the ongoing decarbonisation of electricity supply. Importantly, the subsidy arrangement cannot be altered retrospectively offering predictable earnings and by association dividends, as long as the wind blows and the sun shines.
Crest Nicholson: Housebuilding has been viewed as the exemplar of boom and bust. However, we feel the sector has matured and is now focused on return on equity and free cash flow rather than volumes. This discipline means that many in the sector offer high yields. We have a preference for Crest since it is a leader in low energy housing and sustainable construction. This helps in securing planning and joint ventures with local authorities.
Peter Michaelis is head of equities at Alliance Trust and Stephen Porteous is a global income specialist at Alliance Trust. The views expressed above are their own.