The Income Investor: don’t overlook these dividend stocks

Many income investors immediately turn to the FTSE 100 index when seeking dividend stocks. While this is understandable, given the index’s 3.9% yield, geographic diversification and the attractive valuations of many of its incumbents, it means missing out on the vast income appeal of the FTSE 250 index.

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Significantly, the mid-cap index’s yield is currently roughly equal to that of the large-cap index. And, while the FTSE 250’s constituent companies generate a lower proportion of their revenue from overseas compared with FTSE 100 members, they nevertheless retain substantial international exposure that provides an ample amount of geographic diversification for investors.

In fact, around 39% of sales made by mid-cap stocks are derived from abroad, versus 57% for large-cap shares. Therefore, the financial performance, and dividend prospects, of FTSE 250 index members are likely to significantly improve as the global economy’s outlook strengthens. Indeed, according to the Organisation for Economic Co-operation and Development (OECD), the world economy’s growth rate will increase from 2.7% this year to 2.9% next year as an era of rapid monetary policy tightening comes to an end.

The UK’s improving economic prospects

The FTSE 250’s greater focus on the UK vis-à-vis the FTSE 100 could prove to be an advantage, rather than a disadvantage, for income-seeking investors. The UK economy’s improving prospects could catalyse the financial performance, and dividend growth rate, of mid-cap stocks over the coming years.

The UK economy is undoubtedly lagging many of its developed market peers at present. Although it is now widely expected to avoid a recession in the current year, the International Monetary Fund (IMF) forecasts GDP growth of just 0.4% in 2023. This compares unfavourably with the economic outlook for the US and Japan, for instance, which are expected to grow by 1.8% and 1.4%, respectively, this year. However, next year, the UK’s forecast 1% GDP growth rate is set to match that of both countries, which could have a positive impact on the dividend prospects for FTSE 250-listed firms.

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So, too, could falling inflation. Although the pace of price rises remains significantly above the Bank of England’s 2% target at 7.9%, and is therefore higher than inflation rates in the US (3%) and the Eurozone (5.3%), it is expected to fall rapidly over the coming months. In fact, the Bank of England estimates that inflation will fall to 2.8% by the third quarter of 2024, and then to 1.7% a year later as the full impact of monetary policy tightening is felt.

An inflation rate that is close to, or even below, the central bank’s target may prompt widespread calls for interest rate cuts. This could further boost the UK economy’s prospects, thereby creating operating conditions that are more conducive to profit growth and rising shareholder payouts.

Mid-cap appeal

Of course, the FTSE 250 index has been hugely unpopular over recent years. In fact, it currently trades 9% lower than it did five years ago and has lagged the FTSE 100 index by eight percentage points over the same period.

As a result, many FTSE 250 shares trade on extremely low valuations, and high yields, that suggest they are grossly mispriced given their financial standing and long-term prospects. Investors who are willing to focus on company fundamentals, rather than following the views of their peers, can capitalise on favourable risk/reward opportunities among mid-cap dividend stocks.

Source: TradingView. Past performance is not a guide to future performance.

Although FTSE 250 companies are often viewed as growth stocks, rather than income shares, this standpoint may currently be out of focus. As highlighted, the mid-cap index offers a similar yield to the large-cap index and, since its members are smaller companies than their larger peers, they have greater potential to generate profit, and dividend growth over the coming years.

In many cases, FTSE 250-listed companies are mature businesses that are well-established in their respective industries. In contrast to many small-cap stocks, they do not require a large proportion of excess capital to be reinvested for future growth. As a result, they are likely to have a large capacity to pay out a sizeable proportion of profit as a dividend each year.

While mid-cap shares do not offer the size and scale of FTSE 100 businesses, and may therefore be deemed relatively risky by some income investors, a significant proportion of mid-cap stocks have excellent financial positions and wide economic moats. As a result, their risk/reward opportunity is highly favourable for long-term income seekers.

ITV

Having fallen by 15% over the past six months, shares in FTSE 250-listed media company ITV (LSE:ITV) now offer a 6.8% dividend yield. Crucially, the company’s dividend payouts are covered more than twice by profit as it seeks to navigate a hugely challenging advertising market.

Indeed, the company’s recently released first-half results showed that revenue declined by 1% as demand for TV advertising came under pressure amid a weak economic environment. As a cyclical company, ITV is highly dependent on the macroeconomic outlook and should therefore benefit to a greater extent than most firms from the UK’s improving GDP growth prospects.

With the company planning to increase dividends per share as profits grow, the stock offers much more than just an exceptionally high yield. It also has capital growth potential as its investments in digital services begin to pay off, with the firm expecting to generate at least £750 million in annual digital revenue by 2026. This represents around 20% of last year’s sales.

Furthermore, with a relatively modest net debt-to-equity ratio of 40% and interest cover of 3.5 in the first half of the year, the firm has the financial strength to overcome a tough period for the wider media sector. It also expects to deliver cost savings of £50 million between 2023 and 2026, which will further enhance its financial prospects.

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Trading on a price-to-earnings ratio of 7, ITV’s share price offers a wide margin of safety. For long-term investors who can look ahead to a stronger operating environment, the company’s high yield, low valuation and solid financial position are likely to hold significant appeal.

British Land

Real estate investment trust (REIT) British Land Co (LSE:BLND) has also fallen out of favour among investors over recent months. Its shares have declined by 27% in the past six months as the economy’s weak performance and rising interest rates have weighed on the commercial property sector. Indeed, the value of British Land’s property portfolio fell by 12.3% in its latest financial year.

However, the firm’s solid financial position, as evidenced by a loan-to-value (LTV) ratio of 36% and lack of requirement to refinance any debt until 2026, means it is well placed to pivot towards supply constrained market segments such as urban logistics assets.

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With a price-to-book ratio of just 0.6, the company’s shares offer a wide margin of safety and capital growth potential. In addition, a 6.9% yield highlights their income appeal. And with an improving economic outlook, as well as the potential for a more dovish monetary policy, the company’s prospects are likely to strengthen over the medium term. This could positively catalyse its share price, and dividend growth rate, over the coming years.

Clearly, British Land and ITV are decidedly unpopular among investors at present. As with many FTSE 250-listed companies, though, they have highly attractive yields, dividend growth potential and solid financial positions. As such, they offer more favourable risk/reward opportunities than many FTSE 100 dividend stocks and are worth including in a long-term income portfolio.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.