10 quality income stocks with momentum

Finding high yields is one thing, but what about quality dividend-payers with improving prospects?

There is an ever-expanding arsenal of technical indicators designed to spot changes in share price momentum - but investors have much less choice when it comes to gauging the fundamental momentum in a company’s financial health.

One such measure is the Piotroski F-Score.

Perhaps the biggest appeal of this F-Score is that it captures fundamental momentum in a single number that is easily comparable across companies.

The Score itself is a simple but effective checklist: nine rules that a company either passes or fails, making for a score of between zero and nine.

These checks are grouped under three headings: profitability, leverage and liquidity, and operating efficiency. Six of them record year-on-year changes in various financial health measures, meaning that, compared to other measures, the F-Score tells us more about the direction in which a company's financial state is moving.

There is a growing body of work out there that suggests this score is a strong predictor of long term company health and share price fortunes - especially when it is used in conjunction with dividend yield to identify high-quality dividend payers.

High yields versus sustainable yields

Back in 2012, a Société Générale research note found what other papers had also concluded before it: investment strategies focusing on the highest forecast yielding stocks often carry with them a high risk of financial distress and dividend cuts. This is why it is important to screen for sustainable income - high yields alone can flatter to deceive.

But finding sustainable yields in the stock market is easier said than done. Over the past year or two, some of the best dividend track records in the market have fallen (with Vodafone (LSE:VOD) being perhaps the most notable example).

A consistent dividend history isn't necessarily the best indicator of dividend sustainability. The Soc Gen team found that 'balance sheet quality' as they define it is a far greater indicator.

Further, much research has shown that 'quality' stocks tend to outperform low quality stocks. Here, quality means 'financially robust' - having not only a strong balance sheet but also good underlying business economics.

So, taking the above logic, we can construct a screen for high-quality dividend-payers with improving fundamental momentum (and, consequently, improving prospects) by looking for high F-score stocks yielding above a certain threshold. 

Quality income stocks with positive momentum

Here are the ten highest F-Score candidates we get when screening for an F-Score of 8 or 9, a yield of above 2%, neutral or positive relative strength against the market, and a market cap of above £100 million:

Source: Stockopedia

These are companies whose financial characteristics suggest they can continue to pay out in future - and many of them come with surprisingly attractive dividend yields.

That said, there are some caveats - notably the prevalence of Basic Materials stocks (EVRAZ (LSE:EVR), Anglo Asian (LSE:AAZ), BHP (LSE:BHP), and Macfarlane (LSE:MACF)) and Industrials companies (Andrews Sykes (LSE:ASY), Goodwin (LSE:GDWN), iEnergizer (LSE:IBPO), and MITIE (LSE:MTO)).

These are two cyclical sectors and this should be factored into any conclusions. In including the F-Score, we are at least identifying cyclical companies with favourable business economics and improving financial health trends. 

A great research paper by Robert Arnott many years ago showed that contrary to expectations, companies which pay out a higher proportion of their earnings as dividends actually grow faster.

The reason for this is because company management is generally very bad at allocating capital - wasting resources on empire-building or bad acquisitions. Actually taking cash away from the company can improve the discipline and skill of managers at reinvesting capital. 

The Soc Gen paper confirms this finding and indicates that high yielding stocks outperform as a result of this better capital allocation.

So the idea of bringing both quality and income together, as in the screen above, doesn't just help identify sustainable yields - it increases the chances of finding those companies with superior capital allocation policies and prudent financial management. 

About Stockopedia

Stockopedia helps individual investors beat the stock market by providing stock rankings, screening tools, portfolio analytics and premium editorial. The service takes an evidence-based approach to investing, and uses the principles of factor investing and behavioural finance to help investors make better decisions.

• Interactive Investor readers can enjoy a two-week free trial and £50 discount to Stockopedia using the coupon code iii014 - click here.

These investment articles are simply for generating ideas. If you are thinking of investing they should only ever be a starting point for your own in-depth research.