10 defensive dividend stocks and a checklist for income hunters

Dividend stocks are more popular than ever, but there are some rules you need to know to get it right. Stock screen expert Ben Hobson identifies income stocks for risk-wary investors.

Against a volatile economic backdrop this year - and one that got more alarming this week - many investing styles have been under significant pressure. With markets flat or falling depending on where you look, popular stock-picking styles such as growth, momentum and even value have struggled to pay off.

But there have been bright spots. Amid all this turmoil, high-quality shares have performed better than most - especially larger, more defensive names with dependable cash flows and big dividends.

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In previous periods of recessionary bear markets, solid companies in sectors that are less sensitive than others to the economy have tended to do the best. And that’s what we’re seeing this time around, too.

Getting to grips with company quality

When it comes to the forces that drive returns in the stock market, ‘quality’ is one that means different things to different investors. High profitability is usually the most important clue, especially in firms where profits turn quickly to cold, hard cash.

Believe it or not, these kinds of companies aren’t always in favour. For more than a decade, the market has much preferred so-called ‘long-duration’ shares. These come with the promise of strong cash flows years down the line, but in the meantime it’s a waiting game.

But with fear of recession in the air, attention has turned to ‘short-duration” shares. Forget the promise of future growth, investors are grasping certainty where they can find it. And nowhere do you get greater certainty than in dependable, cash-generating firms that have at least some protection from economic headwinds.

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While profitability and cash flows are important quality markers, a very much related measure of financial strength is the dividend. Firms that make regular cash payouts to investors are naturally appealing when share prices are under pressure.

Moreover, in a period when inflation is running hot and interest rates are likely to rise much further, these payouts become even more desirable. They mean that even when prices are falling, your investments can be generating tangible returns.

A three-point checklist for dividend investing

For some investors, dividends are so important that they become the focus of their investing strategy. For others, they are an essential extra check as part of a wider strategy. Either way, there are three main considerations when it comes to analysing dividends: yield, growth and safety.

Yield is the measure of return: the relationship between the price per share and the dividend per share. Higher yields are often more attractive, and many have risen this year because of falling share prices. But it’s important to consider whether the payout is sustainable, and this is where growth comes in.

Dividend growth over years can be a positive sign of reliability of a business and its cash flows and the confidence of its management team. So much so that some dividend investors prefer a strong growth record to a high yield. Whichever your preference, it’s worth considering the third influence on dividends, which is safety.

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Dividend safety is all about the robustness of the company that pays it. Has it got a strong balance sheet? Does it have a lot of debt? Can it afford the dividend? One important measure to look at is ‘dividend cover’, which tells you the degree to which the payout is covered by the company’s net income. Dividend cover of more than ‘1’ tells you that the payout is sufficiently covered by annual profits - but the higher the better.

To give you an idea, this screen looks for yields of more than 3.5% in companies with a market capitalisation of more than £400 million. The results exclude sectors that are most sensitive to the economy, including consumer cyclicals (such as retailers and housebuilders), financial services (banks) and real estate.

The list is ordered based on the number of years that each company has grown its dividend. Bear in mind that many firms suspended payouts during the Covid pandemic. So it’s worth taking a longer-term view by looking at the five-year average growth rate in the payout.

With a number of these companies selling-off heavily over the past year, the yields on them have risen as a result. Again, it’s important to look beyond the yield to the variables that might impact on the payout.

As an example, National Grid (LSE:NG.) has a long track record of dividend growth over the years, but the actual percentage increase is fairly modest over that time. It’s yielding a very high 5.6%. Importantly, its operations in the utilities sector put it in one of the best performing areas of the market this year. But of course, government intervention and unpredictable price changes in energy markets would be worth considering.

The highest yield in the list is the 12% on offer at chemicals company Synthomer (LSE:SYNT). Shares in the firm have fallen by 72% on a relative strength basis over the past year. Ordinarily, this might have the signs of a red flag, with the exceptional yield and dire price performance indicating that the market has worries for the payout. Further investigation would be important here.

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Finally, another company on the list is Sainsbury (J) (LSE:SBRY), which as one of the UK’s main supermarket groups classifies as a consumer staple - a business that people will use regardless of the economic conditions. It has an eye-catching yield of 6.8% and a payout that is reasonably well covered by earnings. However, price inflation and the cost-of-living crisis could affect supermarkets in various ways, which is worth thinking about.

A takeaway from this screening approach is that there is a sense of market dislocation in places, with investors trying to make sense of the broader economic picture. Substantial price falls reflect general unease and worries about inflation, interest rates and recession. 

The job of the income investor is to plot a way through the market that avoids those companies that could be badly affected. Some industry sectors will be better protected than others. Where share prices have been unreasonably marked down, the higher yields on them could offer a chance to lock in some unusually high dividend returns.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.