Once you have established a solid foundation of dividend knowledge and understood the differences between the various types of dividend shares, you are ready to start prospecting for potential income investments.
Today I’ll discuss how you can get started in the dividend research process.
Panning for golden ideas
Poring over each of the 600-plus companies listed in the FTSE All-Share index to identify a few promising ideas is an arduous and time-consuming task.
Fortunately it’s a task that’s been rendered unnecessary by one of the most glorious by-products of the Internet: the share screener tool.
The primary purpose of a share screener is to reduce the vast number of potential portfolio candidates to a handful of names that you can research further.
You simply enter a few key parameters and the screener displays the select companies that fit your chosen attributes.
One important point to make right away is that screener results should not be considered automatic buy lists. Further research is always necessary, as screener results don’t always tell the whole story. (In the next two articles, we’ll discuss this process for researching individual shares.)
A number of helpful screening tools are available to UK investors online, including:
Premium screeners (i.e. not-free)
If you’re just starting out, the free screeners will do the trick. More experienced investors may want to try the premium screeners, but for our purposes here we’ll just use the free screening tool from The Telegraph.
How to screen for high yield shares
In the previous article in this series, we defined ‘high-yield’ shares as shares with dividend yields between 1.2x and 2x the market average.
With the FTSE All-Share average yield currently near 3.6%, we can begin screening for high yield shares by entering 4.2% to 7.2% into the ‘dividend yield’ parameter about two-thirds down the screener page.
If you try this dividend yield range in a share screener tool, however, you’ll find that you get a list of several dozen companies in the results. For a more manageable hit list of potential high yield investments, we’ll need to enter a few more parameters into the screener to further narrow our search.
With high-yield shares, dividend sustainability is more important than growth potential — a high yield does us little good if the payout gets cut in the subsequent year — so the extra parameters will be designed to help us identify companies with the ability to maintain their current dividend and ideally grow it each year.
To identify high-yield shares that are likely to maintain their payouts in the coming years, we can enter the following five parameters:
- Index: FTSE All-Share. Whilst there may be good opportunities among AIM-listed shares, most investors will want to hold their dividend shares within the tax shelter of an ISA. They’ll therefore need to own LSE-listed shares and to avoid AIM-listed shares.
- Return on equity > 10%. Companies that are unable to consistently generate returns on equity above 10% are likely destroying shareholder value. Even though high-yield companies aren’t usually high growth companies, we nevertheless want to own shares that are at least earning their cost of equity each year. Searching for companies that generate at least 10% return on equity is a fair place to start.
- Dividend cover > 1.2 times. The Telegraph share screener tool does not have free cash flow cover, but the earnings-based dividend cover will do for now. (We’ll discuss calculating free cash flow cover in the next article.) Another way to think about this metric is that a company with 1.2x dividend cover is paying out 83% of its earnings as dividends (1/1.2). This is the absolute minimum amount of dividend cover that investors should demand when researching high-yield shares, in my opinion. Without the ‘margin of safety’ afforded by a well-covered dividend, a year or two of lower earnings could force the company to reevaluate its dividend policy.
- Five year turnover growth > 0%. Sales are the life-blood of the financial statements, so companies with declining turnover may be steadily shrinking. Companies in a state of secular decline usually feel pressure to take drastic actions to maintain profitability, such as a large merger or massive restructuring plan. Those situations can be messy and all else being equal we want to avoid getting entangled in them, because dividends can come under the chopping block in an effort to boost cash flows.
- Five year EPS growth > 3%. Similarly, we also want to see at least a little growth in earnings per share. A situation where a company’s EPS is contracting whilst dividends per share are growing is simply unsustainable. Eventually the dividend will come under pressure. Because we want our high-yield shares to grow at least modestly in the coming years, we want to see a recent track record of positive EPS growth.
By adding these five parameters, we get a much more manageable list of shares to research:
Though we still have some work to do — particularly on valuation — the screen has helped us identify some promising high-yield research candidates. My next article in this series will discuss how to further research high-yield shares once you’ve found them via a screen.
Screening for dividend growth shares
To screen for ‘dividend growth’ shares that may have lower starting yields but have more potential to grow future payouts at high rates, we simply need to make a few adjustments to our screening parameters.
Since we’ve previously defined dividend growth as shares between 2% and 1.2 times the market average, we’ll change the dividend yield range to 2% to 4.3%.
We’ll again stick with just FTSE All-Share stocks in this screen to make sure they are ISA-eligible.
Here are a few more settings:
- Return on equity > 15%. Companies that consistently generate returns on equity over 15% likely have some type of sustainable competitive advantage. Otherwise, you would expect competitive forces to drive ROE downward to the company’s cost of equity. Although ROE does have some flaws (which we’ll discuss in the next article), screening for companies with ROEs over 15% give us a better chance of finding shares with the ability to produce high rates of return.
- Dividend cover > 1.5 times. When looking for dividend growth ideas, we should demand more dividend cover than in the case of high-yield shares for two reasons. First, because we want to identify firms with higher growth rates than high-yield shares, we naturally want these companies to retain a meaningful amount of profit each year to reinvest in the business to promote sustainable longer-term growth. Second, by starting with a higher dividend cover ratio, we’re giving dividend growth shares the potential to grow into a lower dividend cover as they mature. A dividend growth share that’s consistently paying out 90% of earnings today, for instance, doesn’t have much room to augment its payout ratio as growth slows and is thus primarily dependent on earnings growth to deliver dividend growth.
- Five year dividend per share growth > 7%. Just because a company may have the financial strength to increase its dividend at a high rate, it doesn’t mean that the company’s board will do so. For instance, the board could prefer to employ share repurchases or engage in aggressive M&A rather than pay out free cash as dividends. By identifying shares with a track record of raising dividends, we stand a better chance of avoiding companies not fully committed to their dividend programmes.
- Five year EPS growth > 7%. Whilst companies can artificially boost earnings per share using buybacks, most corporate boards of directors use EPS-based payout ratios when determining dividend policy. If the board is seeing strong EPS growth, then they’re more likely to boost the dividend at a similar pace.
As you can see, we have plenty of good ideas to research and from a variety of sectors, too, including financials, commodities, consumer goods, and technology.
We’ll take a closer look at this list of dividend growth ideas after we discuss high yield shares in the next article.
Still more to do
Share screening tools have greatly simplified what was once a time-consuming task of idea-generation. Nevertheless, a successful screen is just one part of a complete research process.
Over the course of the next two articles, we’ll discuss how to use screener results to select the best of the best ideas.
In the meantime, why not try your hand at a few screens and see how they can work for you? And if you have any of your own screening tips, please share them in the comments box below!
You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.